Where there's a will ..

With the price of average London property now exceeding the current nil-rate band, the need for inheritance tax (IHT) planning has never been greater. Gerry Warner considers some effective ways of mitigating the potential tax charge

There are now many homeowners who are cash-poor and asset-rich as a result of rising house prices - even if the one and only asset is the family home. Those who plan to leave the family home to their children or grandchildren simply don't realise they or their beneficiaries could face a very real problem. "It might be a long way off", "it's too complicated" and "it can't really affect me can it? All I have is my house!" could all be typical responses from the average homeowner.

This last reason is likely to have a major impact on the thinking of the ordinary homeowner, who may subsequently decide not to take any action. Such inertia may be preventing advisers from reaching out to those homeowners and helping them to mitigate a potential IHT liability.

Despite the chancellor agreeing to raise the nil-rate band to £350,000 by 2010/11, with house prices continuing to rise IHT is set to become a bigger issue than ever before.

How IHT works

At present, the first £300,000 of a person's estate is taxed at a nil rate with any remaining estate taxed at 40%. Any assets passing between spouses and civil partners are exempt from IHT without limit provided that both spouses/partners are domiciled in the UK.

So if spouses/partners leave their estates to each other, there will be no IHT liability due when the first dies. However, when the second dies, if the value of their estate (including whatever passed from the first spouse/partner) is in excess of the nil-rate band, the excess will be subject to tax at 40%. While each spouse/partner has their own nil-rate band, the first to die's 'allowance' cannot be utilised on the death of the second.

Before we look at IHT planning in more detail, let's first consider the role of wills in protecting an estate for future generations.

Importance of will-writing

Successful long-term financial planning requires the writing of a will for each spouse/partner. If no will exists, the deceased is deemed to die 'intestate' and the estate is distributed in accordance with the laws of intestacy.

Leaving a will allows a person's estate to be distributed in accordance with their wishes. It allows the appointment of an executor(s) who will take control of the estate, pay any debts, expenses, any IHT, and then distribute the balance to the beneficiaries.

Simple 'mirror' wills usually leave the estate of each spouse/partner to the other. When the second spouse/partner dies, typically the estate passes to a third party such as children or grandchildren, which can give rise to a tax liability if the nil-rate band is exceeded.

Careful planning can help minimise this potential tax liability and this involves utilising some or all of the nil-rate band of the first spouse/partner to die. This can be done by wording the wills in such a way as to make provision, on the first death, for assets up to the value of the nil-rate band to be passed at that time to the proposed eventual beneficiaries on the second death. This could be by way of an outright gift, giving the beneficiaries full ownership, or via a trust created by the will, giving the trustees a degree of control. The remainder of the estate passes to the surviving spouse/partner exempt from IHT.

Let's now consider how trusts can be used to mitigate any IHT liability.

Effective trust planning

Prior to the 2006 Budget, intermediaries tended to use just three types of popular trust: bare, discretionary and interest in possession.

Interest in possession (IIP) trusts were historically by far the most popular due to their combination of flexibility and tax treatment as potentially exempt transfers. However, since the 2006 Budget, new IIP trusts are treated for IHT in the same way as discretionary trusts.

Importantly, though, pre-Budget IIP trusts that continue to receive regular premiums, for life plans, are not caught by the new rules. Increases to these plans will also avoid the trust being brought into the post-Budget rules if they form part of the policy contract conditions.

Discretionary trust taxation

Gifts into discretionary trusts that are above the prevailing nil-rate band - taking account of any other chargeable lifetime transfers made by the settlor in the past seven years - are taxed on the amount that exceeds the nil-rate band at half the death rate, currently 20%, when made.

The trust also pays a periodic charge every 10 years on any assets valued above the then nil-rate band. This tax charge is a maximum of 30% of the lifetime rate. The maximum charge is 6% but it is often much less than this. When capital is distributed to a beneficiary there may also be an exit charge. The charge is measured by the amount of the loss to the trust.

Currently, any chargeable lifetime transfers that cause chargeable lifetime transfers in a tax year to exceed £10,000 must be reported to HM Revenue and Customs (HMRC) on forms IHT100, IHT100a and 734. The same rule applies if the cumulative total of transfers over 10 years exceeds £40,000 using these same forms. These limits apply today but it is likely they will be increased in 2007/08.

Generation jumping

Discretionary trusts have typically been used for generation jumping. For example, if a third generation of potential beneficiaries inherit the trust's assets, IHT is saved on the estate of the previous two. The difference in taxation lies in the fact that there is no interest in possession at outset and neither is one imposed by a certain age.

This brief overview does not represent all the possibilities that must be considered but, in summary, the trust can run for its full perpetuity period, usually 80 years, without its assets being attributable to an individual's estate for IHT purposes.

If the client does not want to face the possibility of these tax charges, he or she could consider bare trusts.

Bare or discretionary?

Bare trusts are not settlements for IHT purposes and gifts into them are classed as potentially exempt transfers. Advisers may choose to use bare trusts for this reason. However, they must consider the fact beneficiaries and their share of the trust have to be specified at outset and this cannot later be changed.

If a settlor requires flexibility in the choice of their beneficiaries, either now or in the future, it is likely that a discretionary trust may still be the solution looking forward. Conversely, if the settlor is certain as to who they wish to appoint as beneficiaries, a bare trust may be a simpler solution - at least from a tax perspective. So, there is a simple choice to be made by the client. Do they want flexibility and, if so, are they prepared to accept the more complex tax rules?

A valuable tool

Things have changed, but the discounted gift trust continues to be a valuable tool for intermediaries to use to help clients reduce an IHT liability.

HMRC has confirmed the chargeable lifetime transfer is the discounted gift - the value of the fund minus the settlor's right to capital payments. If the discounted gift is below the available nil-rate band, there will be no entry tax charge. However, there may still be a requirement to report the chargeable lifetime transfer to HMRC.

At the ten-year point, it is possible to revalue the trust without the need for underwriting, provided the settlor was underwritten at outset. HMRC has provided a simple way to calculate the settlor's rights at this time. Provided the trust value minus those settlor's rights does not exceed the available nil-rate band, there will be no periodic charge. If the entry and ten-year periodic tax charges can be avoided, which in turn will avoid the exit charge; there is great flexibility with no lifetime cost.

In addition, discounted gift trusts can now be written as bare trusts and we have seen a number of products enter the market designed to help intermediaries make the most of this. With these trusts, trustees are obliged to make capital payments back to the donor but while it is possible the fund will exceed the level required to maintain the donor's payments, the beneficiaries cannot normally force the trustees to make any payments to them while the donor is alive.

Let's now consider how life policies can form part of the estate planning process.

Whole of life plans

Life assurance, of course, has always played a major part in any good tax planning. Whole of life plans can provide the required sum of money to meet an IHT liability and provided it is written in trust, it will itself fall outside the deceased's estate for IHT. Writing it in trust also means there's no need to wait until probate for the insurer to pay out - all that's needed is a death certificate and the signature of the trustee.

A growing need

So, we find ourselves in a situation where we have a growing client need that increasingly needs to be addressed. IHT is an area where financial advisers can really demonstrate their worth and there's no more appropriate time to be addressing it.

In terms of clients' needs, there is growing recognition that these are often older, important clients, requiring more intense underwriting, with higher sums assured, which is an area where advisers can add value to the client experience.

Advisers who are up to date on this issue can offer a range of solutions and have a great opportunity to add real value to both existing and new clients.

In a world where advice increasingly takes second place to price, this is a great opportunity for the industry to address the needs of not only this generation, but also of those to come.