Nil-rate band discretionary trusts

What is a nil-rate band discretionary trust?

A discretionary trust is a commonly-used type of trust that is set up so that all income and benefits from the assets held in the trust are distributed at the discretion (hence the name) of the trustees. These trusts can be used for all sorts of reasons - such as in family tax planning, where wealthy families want to keep an eye on their trust funds to prevent cash being squandered. When it comes to IHT planning, appropriate individuals could opt for a specialised version of this arrangement, called a nil-rate band discretionary trust.

The discretionary trust framework is used but the real aim is to provide a "wrapper" to shield assets to the value of an individual's IHT exemption (also referred to as the nil rate band) £300,000 in 2007/08 rising to £350,000 in 2010). The exemption is like a voucher to be used after your death so that no inheritance tax is paid on the first £300,000 in the estate. Heirs pay 40 per cent tax on every penny above this figure.

If everyone gets this 'free' £300,000 voucher, why do they need to keep it hidden in a special trust?

Because, left unadvised, married couples only get one crack at the £300,000 exemption between them. It works like this: the first spouse, for example, the husband, dies. Wills are usually drafted so all assets pass automatically between married couples after the death of the first partner - so the wife gets the enormously expensive house, investments, and so on. Inheritance tax is not charged between married couples.

But when the second spouse dies, the whole estate is liable for IHT, minus the second spouse's £300,000 nil rate band (it is called nil rate because it is taxed at 0 per cent).

The nil-rate band trust allows a couple to make use of both their individual £300,000 exemptions (2006): once when the first partner dies, and again when the survivor does.

So how does that work?

First, the home ownership has to be adjusted so it is held by the couple as "tenants in common". Then the couple make new wills to create the discretionary trust (which becomes effective when the first spouse dies). When the trust is triggered by death, there's an immediate bequest of the value of the nil-rate band for IHT - currently £300,000 - from the survivor's assets, to be held in the discretionary trust.

This can be a part-share of the deceased's interest in the family home, for example, given to the trust, or an IOU note given to the trust to the value of £300,000 to be paid out of the survivor's estate after her death. Either way, the survivor can go on living in their lovely home.

So how much actual IHT does this save?

Because the couple is getting two bites at the IHT-saving cherry, their heirs will save the tax they would otherwise pay on the £300,000 that's been removed from the estate. So that's a saving of £120,000 (40 per cent of £300,000). If set up properly therefore, a £600,000 property (06/07)could effectively be sheltered from inheritance tax.

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For further information, please email estateplanning@Howards.co.uk or call our customer services team on 0800 0237993

Levels and bases of, and reliefs from, taxation are subject to change.