Inheritance tax - what Phizackerley happened

The nil-rate band discretionary will trust arrangement, used by many couples to limit inheritance tax liability after their deaths, has been called into question. A big tax bill could be faced by up to 500,000 families with such wills, because inheritance tax (IHT) is levied at 40% of the value of an estate's assets above the nil-rate band of £300,000.

In essence, because of a recent ruling by the Special Commissioners in favour of HM Revenue & Customs (HMRC), the efficacy of this tax avoidance scheme would now appear to depend on whether a partner has worked and financially contributed to the mortgage and which partner dies first.

A couple called Phizackerley precipitated this tax alarm. The nil-rate discretionary trust procedure typically involves splitting the value of the home between husband and wife so that both may fully utilise their respective IHT allowances.

According to Scottish Widows, 4 in 10 households (some 10 million families) are at risk of paying inheritance tax, as the IHT threshold of £300,000 has failed to keep pace with rising house prices.

How discretionary will trusts usually work

To implement a discretionary will trust a married couple or civil partners (the option is not available to unmarried partners) must own their property as tenants in common , not joint tenants . When a partner dies the house will pass to the surviving spouse with no inheritance taxpayable because transfers between spouses are tax free.

Wills are drafted so that assets up to the allowance of £300,000 can be transferred into trust at the time of the first death for the benefit of the couple's heirs. To avoid selling the home, a clause allows settlement to the trust by means of an IOU against the surviving spouse. When the survivor dies, the trust calls in the loan which is deducted from his/her estate.

Why it didn't work

In the Phizackerley case the Special Commissioners (the body that settles disputes between taxpayers and HMRC) ruled that non working spouses may not take advantage of a discretionary will trust arrangement if they have not contributed financially to the building up of a couple's assets. Dr Phizackerley could not write an IOU for something that he had already owned.

26 April 2007 © Moneyextra.com

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