Our previous article considered discretionary trusts and rights to occupy in the context of unmarried partners, focusing on the difficult balance between giving a surviving partner short-term security and what is best option from an inheritance tax perspective.
Similar issues can arise with married clients, but the correct option may be different due to the spouse exemption for inheritance tax.
However, this does not mean that a fixed right for a spouse to occupy a property will always be the best solution. In some cases, relying on the spouse exemption can create unintended tax consequences for the surviving spouse when that right comes to an end.
This article considers advice we provided on a recent case involving a married client, Trevor, who wanted to confirm whether his existing will achieved his wishes in the most tax-efficient way.
Discretionary Trusts and Rights to Occupy: Background
Trevor was widowed in 2008 and remarried in 2014. He has two adult children from his first marriage, both of whom have their own families.
His current wife is financially independent. She had also indicated that, if Trevor died first, she would not wish to remain in the main residence long-term.
Trevor’s estate was valued at approximately £621,000 and consisted of:
- Main residence: £375,000
- Second home: £190,000
- Savings and current accounts: £31,000
- Personal possessions, including car: £25,000
His existing will provided that:
- his children were appointed as executors and trustees;
- his wife was given a right to occupy the main residence for six months after his death;
- at the end of that six-month period, his wife would receive 10% of the property;
- the remaining 90% of the property would pass to his children; and
- residue would pass to his children.
On its face, the will appeared to achieve Trevor’s wishes. His wife would have short-term security and receive a small financial benefit. The majority of the estate would then pass to his children.
The question was whether the will achieved this in the most tax-efficient way.
Inheritance Tax Position
On the figures provided, inheritance tax did not appear to be a significant issue for Trevor.
As Trevor was widowed, his estate may also be able to claim unused nil rate band and residence nil rate band allowances from his late wife’s estate.
If fully available, Trevor’s estate could have combined allowances of up to £1 million.
Assuming transferable allowances are available, against an estate of approximately £621,000 inheritance tax is therefore unlikely to be payable, regardless of whether the spousal exemption applies or not.
The Issue with the Six-Month Occupation Right
A right to occupy under a will would create an immediate post-death interest (IPDI). This means the beneficiary with the right will be treated as inheriting the property for inheritance tax purposes, even if the right is only temporary.
In Trevor’s case, his wife would be treated as inheriting for inheritance tax purposes. The spouse exemption would apply on his death.
The complication arises when the six-month occupation period ends. At that point, 90% of the main residence would pass to Trevor’s children, with 10% passing to his wife. For inheritance tax purposes, the wife would be treated as making a transfer of the value passing away from her. The 90% passing to the children would therefore be treated as a potentially exempt transfer by the wife.
For example, if the main residence is worth £375,000 at that time, 90% is £337,500. The wife will be treated as making a transfer of that amount when her occupation right ends. If she dies within seven years of the trust ending, that transfer would be relevant when calculating inheritance tax on her own estate.
Whilst Trevor has no inheritance tax liability, this may therefore cause her inheritance tax implications on her death.
The Alternative Advice: A Short Discretionary Trust
Our advice was that the will could be reviewed to replace the fixed six-month right to occupy with a short discretionary trust.
Under this approach, the trust would include Trevor’s wife and his descendants as potential beneficiaries. She would not have an enforceable right to occupy the property. Instead, the trustees would have discretion to allow her to remain in the property for up to six months if appropriate and be careful to not give her an enforceable right during that period.
At the end of that period, the trustees could appoint:
- 10% of the main residence to Trevor’s wife; and
- 90% to Trevor’s children.
The trust would initially fall within the relevant property regime for inheritance tax purposes. It would not create an IPDI for the wife.
If the trustees make the appointment within two years of Trevor’s death, section 144 of the Inheritance Tax Act 1984 can apply. This allows the appointment to be read back into the will for inheritance tax purposes. In effect, the will is treated as if it had originally left the assets in the way appointed by the trustees.
The result after the appointment should be that Trevor’s will is treated as leaving 10% to his wife and 90% to his children directly. This would avoid the wife being treated as first inheriting the whole property and then making a potentially exempt transfer of 90% to the children.
Residence Nil Rate Band Considerations
A discretionary trust does not automatically qualify for the residence nil rate band. This is because, at the date of death, the property is not passing directly to direct descendants.
However, section 144 can assist.
If the trustees appoint 90% of the property to Trevor’s children within two years of death, that appointment will be read back for inheritance tax purposes. The children will then be treated as inheriting from Trevor under the will. This allows the residence nil rate band to be claimed retrospectively.
Current values do not require the residence nil rate band to avoid the inheritance tax liability assuming the transferable nil rate band from Trevor’s first wife is available, but this ensures flexibility in case the estate increases in value.
Discretionary Trusts and Rights to Occupy: When Spouse Exemption Planning May Be Useful
Although the discretionary trust was advisable on Trevor’s actual figures, the advice may have been different if the estate was larger.
Assume, for example, that Trevor’s main residence was worth £1 million, while his other assets remained the same:
- Main residence: £1,000,000
- Second home: £190,000
- Savings and current accounts: £31,000
- Personal possessions, including car: £25,000
This would mean a total estate of £1,246,000.
Assume Trevor’s wishes remain the same. He wants his wife to have short-term occupation of the main residence after his death, but he wants 10% of the main residence to pass to his wife and 90% to pass to his children. The rest of his estate is to pass to his children.
Trevor’s estate has total inheritance tax allowances of £1 million, made up of:
- Trevor’s nil rate band: £325,000;
- transferable nil rate band from his late wife: £325,000;
- Trevor’s residence nil rate band: £175,000; and
- transferable residence nil rate band from his late wife: £175,000.
Option 1: Short Discretionary Trust
If Trevor’s will used a discretionary trust, the trustees could allow his wife to occupy the main residence for a short period. They could then appoint the main residence
- 10% to Trevor’s wife; and
- 90% to Trevor’s children.
Section 144 of the Inheritance Tax Act 1984 applies and the appointment would be read back into the Will for inheritance tax purposes. Trevor would be treated as having left 10% of the property to his wife and 90% to his children directly on death.
The inheritance tax calculation after the appointment would be:
- Total estate: £1,246,000
- 10% of main residence passing to wife: £100,000
- Spouse exemption: £100,000
- Value passing to children:
- 90% of main residence: £900,000
- Second home and other assets: £246,000
- Total passing to children: £1,146,000
- Less available nil rate bands and residence nil rate bands: £1,000,000
- Taxable estate: £146,000
- Inheritance tax at 40%: £58,400
This avoids the wife being treated as making a later transfer. However, because the estate passing to the children exceeds the available allowances, inheritance tax is payable on Trevor’s death.
Option 2: Fixed Short-Term Occupation Right for the Wife
Alternatively, Trevor could retain a fixed short-term right to occupy for his wife. This would create an IPDI for inheritance tax purposes.
The wife would be treated as inheriting the main residence for inheritance tax purposes. As she is Trevor’s spouse, the spouse exemption would apply to the main residence.
The inheritance tax calculation on Trevor’s death could be:
- Main residence passing to wife’s IPDI: £1,000,000 (exempt from inheritance tax)
- Other assets passing to children: £246,000
- Less available ordinary nil rate bands: £650,000
- Taxable estate on Trevor’s death: £0
- Inheritance tax on Trevor’s death: £0
In this example, relying on the spouse exemption gives a better immediate inheritance tax result. It avoids the £58,400 inheritance tax charge that would arise under the discretionary trust option.
However, the tax has not necessarily disappeared. It may simply have been deferred.
When the wife’s occupation right ends after six months, 90% of the main residence passes to Trevor’s children and 10% passes to his wife. For inheritance tax purposes, the wife will be treated as making a potentially exempt transfer of the 90% passing away from her.
If the main residence is worth £1 million, the 90% passing to the children would be worth £900,000.
If she survives seven years from the end of the occupation right, that transfer may fall outside her estate for inheritance tax purposes. If she dies within seven years, the £900,000 transfer would be brought into account when calculating inheritance tax on her estate.
This may be acceptable in some cases, particularly where the surviving spouse is in good health and the immediate inheritance tax saving is significant. In other cases, it may create unnecessary uncertainty for the spouse and her estate, in which case having the discretionary trust option may be the better option.
Non-Tax Point to Consider: Provision for the Surviving Spouse
A further non-tax point we advised the potential for a claim under the Inheritance (Provision for Family and Dependants) Act 1975.
A surviving spouse is an eligible applicant under the 1975 Act. The fact that Trevor’s wife is financially independent and has indicated that she would not wish to remain in the property long-term is relevant, but it does not remove the risk entirely.
Where a client intends to leave only limited provision for a spouse, it is sensible for the will to be supported by a detailed letter of wishes. This can explain the client’s reasoning, including:
- the spouse’s own financial position;
- the length and circumstances of the marriage;
- the provision being made for the spouse; and
- the client’s wish to preserve assets for children from a previous relationship.
The letter would not stop a claim, but the court may consider the clients reasons when making their decision.
A forfeiture clause, also known as a no-contest clause, may also be considered. This type of clause can provide that a beneficiary forfeits their benefit under the will if they bring a claim or challenge the estate. It cannot prevent a 1975 Act claim, and the court retains its jurisdiction. It may however have a deterrent effect.
Discretionary Trusts and Rights to Occupy: Conclusion
Trevor’s existing will broadly reflected his wishes. However, the case illustrates why discretionary trusts and rights to occupy require careful consideration when drafting wills for second marriage clients.
A right to occupy could cause his wife a potential inheritance tax problem if she died within 7 years of the trust ending. On that basis, the will could be reviewed to replace it with a discretionary trust. This would help avoid his wife being treated as inheriting the property and then making a later transfer when her occupation right ends.
This would not be the best option for all clients. The most appropriate option will depend on the client’s objectives, the size of the estate and the wider family circumstances.
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This article is provided for general information only and does not constitute legal advice. Any advice, wording or clauses referred to are illustrative and should not be relied upon as precedent without full consideration of the client’s circumstances, the will as a whole, and the law in force at the relevant time.
