Potential Problems with Inheritance Tax and Trusts

Trusts can be a very effective method of reducing a potential inheritance tax (IHT) liability. They offer the opportunity not only to mitigate or eliminate the liability that will have to be paid from an estate upon the death of the estate holder, but also to provide some financial security for their dependants. As such, so-called Nil Rate Band Discretionary Trusts are very popular in the field of inheritance planning. While they are a useful tool, however, there are a number of drawbacks associated with this type of trust.

The purpose of establishing a Nil Rate Band Discretionary Trust is to limit as far as possible the IHT liability of an estate, as this will reduce the total inheritance of the estate holder's heirs. Clearly, this is something that will not benefit the estate holder as any such charge will only be levied after the individual's death. However, establishing such a trust can have significant tax implications during the lifetime of that individual.

Levies on Transfers

The government is aware of the fact that people use trusts to reduce the amount that will ultimately be paid in tax. In recognition of this, an IHT charge is now levied on assets transferred into trusts or companies. This means that, while the original intention of the trust may have been to avoid an IHT bill, the immediate result may simply be to bring the date of that bill forward. It is important to note, however, that IHT charges of this kind are made at a different rate to those that occur post-death; the current standard inheritance tax rate is 40%, but assets transferred into trusts or companies have a charge of only 20% levied.

Furthermore, these transfers are entitled to the same exemptions that apply to normal IHT calculations; charges will only be levied on excess amounts over the Nil Rate Band, currently set at £325,000. While this may still seem to represent a saving, given the lower IHT rate, it demonstrates the limitations of the Nil Rate Band Discretionary Trust. For those with particularly large estates, IHT will still ultimately be payable if the total sum that is not transferred into trust exceeds the Nil Rate Band on the death of the settlor or their spouse.

Somewhat unfairly, individuals can also be penalised for the time of their death. If transfers that exceed the Nil Rate Band have been made into a trust or company within a seven year period before the time of death, still more tax will be due; the liability is recalculated at the regular 40% rate, and the outstanding sum is taken from the estate.

Finally, it should also be noted that the process of establishing a Nil Rate Discretionary Trust can be an expensive one. It is vital that this is done properly, and this will require the help of a solicitor or other legal professional. As their fees can be high, a judgement needs to be made regarding whether or not the potential benefits are outweighed by the immediate costs.