Discretionary trusts can be effectively used to enable a surviving spouse to enjoy the benefit of a fund without the penalty of wasting the ...

Discretionary trusts can be effectively used to enable a surviving spouse to enjoy the benefit of a fund without the penalty of wasting the nil rate band.

For example, assume that husband and wife each have an estate of £500,000; and that the husband dies first wishing his widow to be the primary beneficiary. Under a commonly used, but wasteful alternative, the husband could give his widow his £500,000 estate (absolutely or by way of life interest) ensuring that no IHT was payable on his death.

On her death, however, having regards to the bunching effect, other things being equal, IHT would be payable on an estate of £1m (IHT £290,000 for 2005-2006).

A more sophisticated alternative would be for the husband to give his widow only £225,000 and settle the remaining £275,000 (the 2005-06 nil rate band) on discretionary trust, with informal directions to the trustees to treat the widow as the principal beneficiary.

So, if she was in need, she could have a capital distribution or, perhaps, more appropriately, a loan which should be a deduction from her estate on her death (but watch FA 1986 s.103 – especially if there have been lifetime gifts from her to husband); or she could receive income distributions.

In that case, the IHT at 2005-06 rates would be reduced to £180,000 (i.e. on the widow's then estate of £725,000) and with the discretionary trust fund constituting a nil rate band. There would be an IHT saving under this alternative of £110,000 (£290,000 - £180,000).

This is regarded as one of the most effective – yet relatively simple – IHT savings that can be introduced in a will. Moreover, as the use of variations may become restricted that saving of £110,000 by use of the mini discretionary trust would no longer be a mere alternative to doing a variation!

Note also that the use of s.144 discretionary trusts may become short-lived. By way of contrast, variations are specifically excluded from the Pre-Owned Asset charge in most cases (see FA 2004 Sch 15 para 16).

An additional advantage is that, especially after the death of the surviving spouse, further tax benefits can be obtained by skipping a generation, e.g. in favour of grandchildren, by way of income and/or capital distributions.

Ensure that in lifetime (not merely under the will), husband and wife each have sufficient assets to take advantage of their respective nil rate bands (one never knows who will die first!). This may for example require lifetime severance of a joint tenancy, emphasising the advantage of a joint holding being as tenants in common ? not as joint tenants. If necessary – probably as a last resort – such steps towards equalisation and severance could be achieved by a variation under s.142.

There are some possible danger areas to be borne in mind, although these need not constitute fundamental obstacles. For example, aspects involving related settlements (s.62); the IHT 10 year anniversary and interim charges (ss 64-68); CGT on distributions; avoiding distributions to widow(er) within 3 months of death of the testator spouse; and see Frankland v IRC [1996] STC 735; the 40 per cent income tax “RAT” rate on discretionary trusts. (These are aspects to which we may return in a later article).

The Home Loan/Charging Method
If the home is the main asset in the estate of the first spouse to die, (say) the husband, he could gift the nil rate band in his Will as a monetary legacy to chargeable parties and widow by use of a mini discretionary trust (i.e. so as not to waste the nil rate band: £275,000 x 40 per cent = £110,000).

The residue is left to the widow (i.e. in particular the home but included in the overall share of residue – not specifically). The nil rate band gift (or any shortfall) would be satisfied by a loan or charge on the property in favour of the trustees of the mini discretionary trust.

That loan, charge could be on favourable terms for the widow, e.g. free of interest and deferred as to payment of the capital, albeit preferably, payable on demand by the trustees. Do, however, take careful note of the “sham” warning below.

The loan or charge should then be a deduction from the widow's estate on her death, subject to a possible disallowance if wife (i.e. the surviving spouse in our example) had made lifetime gifts of substance to her husband: FA 1986 s.103. In that event consider giving the widow only a life interest, the trustees of the discretionary trust taking the charge, or loan from the trustees of the life interest trust.

Alternatively, let the personal representatives (not the widow) create the charge before appropriating the home to the widow out of residue. (See also below as to the SDLT aspects).

It has been emphasised above that the home should be within the residuary gift, thereby enabling the personal representatives to appropriate the home to widow, subject to a charge by the personal representatives as appropriate.

The identity of the personal representatives and the trustees of the discretionary will trust should not be identical, especially as to the first named. The surviving spouse should preferably not be an executor, and if appointed in the will she should consider renouncing. This latter method may also avoid Stamp Duty Land Tax (SDLT) which it seems is payable if the widow creates the debt – as it is then arguable that the debt is incurred for consideration.

The concern is that the surviving spouse is in reality purchasing the testator’s share in the home for an amount equal to the debt, and under the rule in Passant v Jackson [1986] STC 164. The Revenue argument could be the surviving spouse’s acquisition of the home constitutes a “land transaction” under FA 2003 s.43 for which the provision of the debt is to a chargeable consideration – see also FA 2003 Sch 4 para 1.

If the charge is created by the personal representatives before they appropriate the home to the surviving spouse, and she does not assume liability for the debt, there should be no SDLT liability and see SP 6/90 and 9/84. Due to some uncertainty as to the correct position, it may be appropriate to limit the debt to a loan of just under £250,000 so that the SDLT rate is 1 per cent; contrasted with 3 per cent if the loan is £275,000 (the nil rate band amount).

However, the contrary ancillary advantage of the widow’s debt/IOU method could be that a subsequent decision by the surviving spouse to move house (e.g. “trade down”) is far less complex as the trustees of the discretionary will trust would not be required to call in the debt upon the sale – they do not have a security.

The widow would have had use and occupation after husband's death. It is important that the trustees should be specifically authorised in the will to allow the charge to be free of interest and to defer calling in the capital (i.e. permitting the payment of the legacy of the discretionary trust, or the appropriate part/balance to be deferred), notwithstanding that one of the trustees is the beneficiary of the home but see below.

Warning: The Trustees Must "Act" - No "Sham"
This loan/debt method in a will has generally been favourably treated by HMRC. However, care should be taken.
The CTO have warned practitioners and trustees and others that it is not sufficient just to have a well-drawn trust deed. The trustees must be active, not passive, and be seen to consider and, as appropriate, exercise their discretions and not just leave the widow(er) in indefinite favourable occupation.

In particular, the trustees must meet regularly, say twice a year, and minute the decisions e.g. as to taking a charge (not just an IOU), charging interest possibly rolled up (such interest, including rolled up, would be liable to income tax, but with a contra for IHT), requiring or delaying repayment of the loan, distribution of any income to the various beneficiaries.

If the trustees just 'sit on their hands' the whole arrangement can be attacked as a sham and/or that the widow has an interest in possession in the whole house (or share) without a deduction of the loan. Wherever practical the widow should not be a trustee of the discretionary will trust, or at least without a trustee veto, the trustees voting by a simple majority which can out-vote the widow.

HMRC is likely to call for the professional advisers' letter setting up the arrangement: word it carefully! (Consider resisting such a request).

As to the importance of the trustees having a discretion as to widow’s use of the home, see the Judge v HMRC case [2005] SpC 506. The discretionary element may negate any interest in possession argument by HMRC.