Inheritance tax is charged on the basis of the value of the deceased's estate immediately before death, added to the value of any gifts made within seven years of death. The first pounds 200,000 (the "nil rate band") is not taxable and the balance is taxed at 40 per cent. There are notable exemptions from this charge, one of the most important being that gifts between spouses are tax free. However, even here there is a catch. If, for example, an Englishman dies leaving his estate to his French wife then the spouse exemption is limited to pounds 55,000 if the wife is not domiciled in the UK.
How can your will save tax? The answer is by both husband and wife using the inheritance tax nil rate band to the full. For example, Mark and his wife Sarah each own assets worth pounds 200,000. In addition, they jointly own their house, worth pounds 175,000. On Mark's death he leaves everything to Sarah. There is no inheritance tax to pay as the transfer is spouse exempt. On Sarah's death, the assets pass to the children. As she will own pounds 575,000 of assets the inheritance tax will be 40 per cent of pounds 575,000 less the nil rate band of pounds 200,000. This gives a tax bill of pounds 150,000.
If Mark's will had provided that pounds 200,000 should pass directly to the children and the remainder to Sarah then the overall tax bill would be much reduced. There is no tax on Mark's death as the gift to the children is within the nil rate band, and the rest is spouse exempt. On Sarah's death, her taxable estate is much smaller so inheritance tax will be 40 per cent of pounds 375,000 less the nil rate band of pounds 200,000. This gives a tax bill of pounds 70,000 - a saving of pounds 80,000.
The most obvious problem with this second scenario is that if pounds 200,000 has been given away to the children, then Sarah may have insufficient to live on in the years to come. This problem can also be overcome. If Mark's will had created a "discretionary trust" he would have been able to ensure Sarah had sufficient to live on and saved the pounds 80,000 of inheritance tax as well.
Smaller amounts given away to children or a trust, on the first death, are also effective. For instance a gift of pounds 50,000 would ultimately save pounds 20,000 of inheritance tax and it could be more if the rate increases in the future.
Even if the will was not drafted appropriately in the first place, it is possible to save tax by using a "deed of variation". If Mark's will had left everything to Sarah then she could, within two years of his death, enter into a deed of variation of the will. This deed would state that Mark's will should be read as though he had made a gift of pounds 200,000 to the children. Provided certain formalities are complied with, the legacy to the children will be treated for inheritance tax as though it were made under Mark's will.
This type of tax planning may not be suitable for everyone. If the asset that forms some or all of the legacy to the children or the trust is the main residence then care needs to be taken. Not only are there tax traps, there is also the issue of whether either spouse should be giving away an interest in is possibly the most important item they own. No planning should ever allow the tax tail to wag the dog
The writer is a partner at the solicitors Lawrence Graham.Reuse content