Trusts are still a good way to keep the taxman at bay

A landmark ruling has left thousands of couples worried that their discretionary trusts are worthless and that a large chunk of their estate could now be swallowed up by inheritance tax. But Peter Sutherland of Andersons Solicitors in Nottingham, insists there are still ways to protect your hard-earned money despite this setback.

The recent ruling by the tax commissioners that a couple’s discretionary trust is invalid because the wife didn’t work and so didn’t contribute to the family wealth has been described as archaic and totally out of step with other areas of law and modern attitudes towards women.

The case involved Oxford University academic Dr Patrick Phizackerley and his wife Mary. Like half a million other couples they set up a trust to ensure that as much of their wealth as possible would pass on to their children instead of going to the taxman. The move is quite common because of the way the current system works.

The threshold at which inheritance tax is payable is currently £300,000. Tax is then payable at 40% on the remainder of the estate. A husband or wife can leave their estate to their surviving spouse without any inheritance tax liability. However, when the surviving spouse dies, the tax then becomes payable by their children or other beneficiaries of their will. The problem has become more acute in recent years as rising house prices mean that four out ten homes are now above the inheritance tax threshold.

The way for couples to reduce this burden is for both husband and wife to make full use of their allowances by setting up a nil-rate band discretionary trust. This enables them to effectively raise the tax threshold to £600,000.

The way it works is like this. When the couple make their wills, instead of leaving everything to each other, they each arrange for their share of their assets up to the threshold figure of £300,000 to pass into a trust for their heirs. The remaining spouse would then be able to continue living in the family home but would owe the trust the £300,000. It’s a kind of I.O.U. to their children.

When the remaining spouse dies, the trust calls in the loan which is deducted from the estate and then passes on to the couple’s heirs free of inheritance tax.

The system has worked well but has now been called into question by the tax commissioners’ ruling in the Phizackerley case. Mrs Phizackerley died in 2000 and left her share in the family home in a trust. Her husband was able to continue living in the house. However, when he died in 2002, the Revenue claimed the arrangement was invalid and the estate would be liable for inheritance tax after all.

The problem, according to the commissioners, was that Mrs Phizackerley had not worked during the marriage and so had not contributed towards the cost of the house and therefore the value that she had gifted to the trust.

The ruling seems out of step with the law’s attitude to women in other areas. For example, in divorce cases there is a general presumption that a couple’s assets should be divided equally even if one didn’t work during the marriage. The sense of injustice is made worse by the fact that had Mr Phizackerley been the first to die then the problem would not have arisen, the discretionary trust would have done its business and there would be no inheritance tax to pay.

The Phizackerley family say they don’t intend to appeal but most commentators believe there would be a good chance of a successful legal challenge. Whether or not that happens remains to be seen but in the meantime, couples should not be alarmed into thinking that such trusts are not worthwhile.

The difficulties encountered in this particular case would only affect a limited number of people, especially if the trusts are properly set up. When a potential problem does arise, there are still measures that could be taken. For example, on the first death, the surviving spouse could consider a Deed of Variation to pass some of their wealth on to their children or an alternative chosen beneficiary. This would reduce the value of their own estate and so reduce the amount of inheritance tax payable on their death.

Of course, the surviving spouse may need to put safeguards in place to make sure they are not disadvantaged by taking such measures.

The issues are complicated and it is important to get good professional advice. The important thing at this stage is to ensure people are not put off using discretionary trusts because they still have a major role to play in mitigating against inheritance tax.

For further details contact Peter Sutherland 0115 988 6714 psutherland@andersonssolicitors.co.uk