Sarah Bradford asks whether nil rate band discretionary trusts still have a role to play in inheritance tax planning.
In days gone by (or more precisely, prior to 9 October 2007), nil rate band discretionary trusts had a very useful role to play in ensuring that one spouse’s or civil partner’s ‘nil rate band’ for inheritance tax purposes was not wasted.
However, since 9 October 2007, the nil rate band has been transferable between spouses and civil partners, and this has reduced the attractiveness of nil rate band discretionary trusts.
What is a discretionary trust?
A discretionary trust is one in which the trustees have `discretion’ as to how the trust income and maybe the trust capital is applied. The trustees are the legal owners of the assets. Any income received by the trusts is taxed. Trust income in excess of £1,000 is taxed at special trust tax rates. Payments made by the trust to a beneficiary carry a tax credit at the trust tax rate, currently 45%.
How do nil rate band discretionary trusts work?
Under a nil rate band discretionary trust, property up to the nil rate band for inheritance tax purposes (currently £325,000) is settled on a discretionary trust. This uses up the settlor’s nil rate band. The discretionary nature of the trust provides flexibility for the trustees to provide for the beneficiaries as required, without having to specify the bequests in advance.
For inheritance tax purposes, anything left to the surviving spouse or civil partner is generally exempt. Prior to 9 October 2007, if a will provided for everything to be left to the surviving spouse or civil partner, the nil rate band was wasted on the death of the first spouse or civil partner. Using a nil rate band discretionary trust prevented the nil rate band being wasted, while allowing the surviving spouse or partner to benefit from the trust.
Transferable nil rate band
Where a surviving spouse or civil partner dies on or after 9 October 2007, the nil rate band available on their death is increased by the percentage of the nil rate band unused on the death of their spouse or civil partner. If the first spouse or civil partner to die leaves everything to the surviving spouse or civil partner, 200% of the nil rate band at current values may be available on the death of the surviving spouse or civil partner.
The transferable nil rate band must normally be claimed within two years of the second death.
Are nil rate discretionary trusts still useful?
The introduction of the transferable nil rate band reduced the usefulness of nil rate discretionary trusts. Although in many cases they are now an unnecessary complication, nil rate band discretionary trusts can still have their uses. For example:
- Surviving spouse remarries – where the surviving spouse remarries, a nil rate band discretionary trust may be useful where the spouse wishes to provide for children from former relationships.
- Second marriage or civil partnership – a nil rate band discretionary trust can also be useful where one or both of them is the surviving spouse or civil partner of a previous marriage or civil partnership with unused nil rate bands to protect.
- To reduce the surviving spouse’s assets – assets are sometimes transferred into trust on the basis that they should not be taken into account by a local authority if the surviving spouse needs to go into care.
- Trust assets increasing at a rate greater than current nil rate band – the nil rate band has been set at the current level of £325,000 since 6 April 2009 and is frozen at this level until at least 2017/18. If trust assets are likely to increase in value, a nil rate band discretionary trust could still be worthwhile.
- To protect claims on assets – placing assets in a trust is sometimes intended to protect them from claims by business creditors or ex-spouses or civil partners.
The trustees can within two years of death make an irrevocable and absolute appointment in favour of the surviving spouse. For IHT purposes, this is treated as if left to the spouse under the will, with the benefit of the inter-spouse exemption.
Practical Tip:
Although nil rate band discretionary trusts are not the planning tool they once were, in certain circumstances they can still be very useful.
