IHT mitigation

A client now married to his second wife came to see me the other day with a question about an interest in possession he has in a valuable plot of land arising under the terms of his first wife's will. Under the terms of his will, his interest in the land will pass to his children from his first marriage on his death. If he dies before his second wife there is likely to be inheritance tax payable on the gift to his children who are non-exempt beneficiaries. Furthermore, the whole of his nil-rate band will be utilised by this gift.

The trust in question, which was set up in the will of my client's late wife, provides for my client to be entitled to the full benefit of the land for his lifetime. On his death, whatever is left in the trust then passes to the children of the marriage.

My client is treated for inheritance tax purposes as the owner of the assets held within this trust. The result is that, on his death, the assets will be taxed as part of his estate and there will be inheritance tax to pay at a rate of 40 per cent of the value of these assets. Based on a recent valuation of the land of £1,500,000, the first £325,000 will be free of inheritance tax (by virtue of my client's nil-rate band allowance) and the balance of £1,175,000 will attract inheritance tax of £470,000.

It is possible, however, for the trust to be reorganised in my client's lifetime, not only to mitigate the inheritance tax position on his death but to all free up my client's nil-rate band so that it can be used against the other assets in his estate.

My client's children will agree to delay their entitlement under their late mother's will trust for six months after my client's death, if he is survived by his second wife. Assuming that the trust contains the necessary powers, the trust will then be varied so as to provide my client's widow with the right to receive the income from the trust for this six-month period.

After the six-month period has passed, the children would become entitled to receive the benefit of the assets held in the trust in accordance with my client's original intention. Assuming that my client's widow is still alive at this point, this would be deemed to be a potentially exempt transfer (PET) by his widow for inheritance tax purposes and therefore it would not be immediately chargeable to inheritance tax as it would have been had the gift taken effect on my client's death.

If my client's widow survives for a further seven years after the end of the six-month period, the gift will be entirely exempt for inheritance tax purposes. Even if she only survives for three years from the end of the six-month period, the rate of tax applicable to the gift will begin to reduce from 40 per cent to 32 per cent in the fourth year, 24 per cent in the fifth year, 16 per cent in the sixth year and eight per cent in the seventh year. The children might wish to consider the option of taking out an insurance policy against their stepmother's life for a seven-year term, or at least for the initial three years until the rate of inheritance tax begins to fall.

If my client's widow does not survive for seven years, the gift becomes a chargeable transfer for inheritance tax purposes and her nil-rate band allowance will be utilised. As a note of caution, it is conceivable that the beneficiaries of her will may be different to those under my client's will. This exercise could therefore have a detrimental impact on these beneficiaries whose inheritance may be reduced. Independent advice may well be necessary.