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Case Study: Who should foot the tax bill on an interest in possession trust?

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The problem: A client’s mother died recently and left her whole estate her only son. His father died five years ago and left everything to his wife, so the client and the other executor of her estate claimed a transferable nil rate band and thought it would mean that no inheritance tax would be payable as her estate was less than £650,000. He has now received a letter from his cousins’ solicitors saying that the executors have to pay IHT of over £80,000 because she received money from a trust fund. Do the executors have to pay HMRC the money?

The solution: The answer is, unfortunately, yes. When someone dies, their estate is valued. This includes their possessions, either held solely or jointly, but can also include other assets if the deceased had the right to benefit from a trust created by a deed or under someone’s will or intestacy.

After further investigation, it turned out the client’s mother had a hard time making ends meet and her brother helped her out financially. Through his will he had set up a trust that would pay an income for the rest of her life. After she died, the whole trust fund went to the client’s cousins.

On the mother’s death, the trust was worth £400,000. As an interest in possession trust established through a will it was included in her estate for IHT purposes. This type of trust arrangement is known as an immediate post-death interest. If the trust had been a discretionary trust, it would not have been included in the estate for IHT purposes.

So the mother’s estate was actually valued at £1m – £600,000 + £400,000. After deducting the nil rate band of £650,000, there was IHT of £140,000 to pay –£350,000 taxed at 40 per cent.

But who should pay this bill? It seems rather hard on the client if the estate paid it and in fact the legislation says that it should be apportioned between him and the trustees of the interest in possession trust.

Arguably, this is still somewhat unfair. But legally as the estate was 60 per cent of the total of £1m, it has to pay 60 per cent of the £140,000 IHT bill – £84,000. The trustees will pay the balance of £56,000 before passing on the trust fund to the nieces.

Assuming that the parties concerned were aware of this situation, what could they have done about avoiding it?

First, the client’s mother could have renounced her life interest. If she had done this within two years of her brother’s death, it would be treated as though she had died before the trust or will came into effect and that the nieces had been given an absolute interest. If she did it at a later date, it would have been a potentially exempt transfer.

But she needed the income from the trust to live on. Alternatively, her brother could have set up a discretionary trust and the trustees could then have distributed the income. However, this could have been subject to periodic and exit charges.

Jeremy Pearson is technical support manager at Canada Life

 

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