Winding up nil rate band trusts
Many Wills made before October 2007 contained “nil rate band” trusts. They were a simple device to save inheritance tax when one spouse inherited from another. In October 2007 the law changed and these trusts were no longer needed to save tax.
Since the trust no longer gives a tax saving the surviving spouse and children face a dilemma following the first death: should they wind up the trust?
Their lawyer has to explain the complex pros and cons of winding up the trust to the grieving family.
Broadly speaking the cons are:
- The trustees must file annual tax returns for the trust, the rate of tax is potentially penal
- There should be annual trustee meetings;
- The inheritance tax nil rate band will be frozen at the rate allowed on the date the first spouse dies. As at January 2015 it is £325,000 and it has been stuck there for many years. However if (as the Conservatives have said they will do) it increases to £1m the family has potentially lost £675,000 of nil rate band by keeping the trust. With tax at 40% up to £270,000 extra tax could be paid.
The pro to keeping the trust is that the amount in the trust (likely to be £325,000) benefits the surviving spouse for life, then goes to the people named as beneficiaries when the surviving spouse dies: normally the children. The surviving spouse may only spend the income from the trust, not the capital.
If there is any doubt that the children will inherit (often an issue with second marriages where the ultimate beneficiaries are not the children of the surviving spouse) then the trust ensures that they will inherit the capital in the trust.
If the combined assets of the spouses is less than £650,000 and is unlikely to increase, it does not matter than the nil rate band is frozen, as there should not be any inheritance tax to pay on the second death.
Whatever the family decides to do they MUST take the necessary steps either to wind up or set up the trust. Either is straight forward to do at the time, but if they do nothing or do not do it properly it can be a minefield sorting it out later.
The trust can only be wound up after 3 months from the death, and before 2 years to be “read back” into the Will. If the trust is neither properly set up or disbanded correctly at the time of the first death it leaves the executors (frequently the children) with an uncomfortable negotiation with HMRC after the second death over the value of the assets in and tax liabilities of the Trust. Income tax and capital gains tax are payable during the life of the trust and when it is wound up.
If the Will contains a nil rate band trust take legal advice, even if it appears that there is no Inheritance Tax to pay at the time.