Shut the taxman out if you've crossed the inheritance threshold

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More people than ever before are using trusts to keep a lid on inheritance tax (IHT) bills.

More people than ever before are using trusts to keep a lid on inheritance tax (IHT) bills.

Although housing market growth is now slowing, many owners have seen price rises push their property value up to the point where IHT - a 40 per cent tax payable on any estate worth over £263,000 - threatens to be a serious liability.

To this end, discretionary trusts have become a popular tool in IHT planning. They can save a married couple up to £105,200 on an IHT bill by making use of both partners' "nil-rate bands".

For example, if a home is worth £400,000 and, on the death of one spouse, it passes to the other without trust tax planning, there will be an IHT bill to pay on the value of the property above the nil-rate band when the second spouse dies. The beneficiaries of their estate - in most cases, their children - must foot this bill.

But if a discretionary trust is set up as part of a married couple's will, assets equivalent to the £263,000 nil-rate band can go into the trust on the death of the first spouse. As a result, these assets - a house, cash or shares - can be put safely outside the IHT net. The widow/er can even, if necessary, draw on the funds if the house is sold.

However, in order to put one spouse's share of a property into trust, the house must be legally held by the couple as "tenants in common" rather than "joint tenants". Many couples buy homes under the latter terms, and so need a solicitor to "sever" the tenancy.

The surviving spouse can then carry on living in the house without having to pay any rent to the trust's beneficiaries, as long as the terms of the trust have been set up to allow this.

Nil-rate band trusts have to observe legal formalities and be properly documented. This point is crucial: trustees must have regular meetings to show that they take their responsibilities and legal powers seriously. Decisions taken during these meetings should be carefully recorded. The Inland Revenue has already made warning noises that it will look at how trusts of this nature have been run.

Trustees can include the widow/er and other beneficiaries, as well as close friends or a family solicitor. Their role is important and can be complex. In particular, they can change the mix of assets held within the trust. For example, if the trust owns or part-owns the family home and the surviving spouse wants to move to a smaller home, the property can be sold and the money used to help with the purchase of the new one.

In this event, the sale proceeds must go through the proper legal channels. The surviving spouse is entitled to receive only the proceeds of his or her share of the house, while the rest will belong to the nil-rate band trust.

A common trap is for the house to be sold and all money to pass directly to the beneficiary instead of through the trust - a move that can jeopardise the IHT saving.

Only once the trustees have received their share of the sale proceeds can they put it towards a new house for the surviving spouse. Alternatively, they may decide to invest the cash for extra income. This can then be paid to the widow/er, or used to pay nursing home fees, say.

If the surviving spouse has no need for the extra income, it could be used to help with school fees or other family expenses. Another option is simply to pay some of the sale proceeds out of the trust back to the widow/er, but this should happen only in cases of financial need. Once the money is paid back in this way, the IHT saving is lost.

From a tax point of view, it is clearly best if a surviving spouse uses his or her own savings first before resorting to the trust. The money held in the trust is in effect the trustees' "IHT-free piggy bank" - not to be raided unless absolutely necessary.

There has also been concern about "pre-owned asset" rules which take effect next April and give rise to an annual income tax charge on certain assets affected by IHT planning. However, these rules will not affect nil-rate band trusts in wills.

To set up a trust, seek advice from an accountant or solicitor specialising in this area. Since there might be more than £100,000 in IHT at stake, it's worth getting the details right.

Mary Hase and Jacqueline Thomson are tax specialists at Smith & Williamson, an independent professional and financial services group.