FOOL'S EYE VIEW
How To Outwit the Taxman

By Jane Mack (TMFJane)
November 28, 2002

Earlier this month in our series of articles about making a Will, we mentioned a court case known as Eversden which was unsuccessfully challenged by the Inland Revenue a few months ago. It provides a loophole by which people can avoid paying vast amounts of Inheritance Tax (IHT).

Yesterday's pre-budget speech from the Chancellor made no mention of IHT but his full report does contain a telling sentence which may have implications in the future. It reads: To ensure that the burden of tax does not fall unfairly on compliant taxpayers, loopholes giving scope for avoidance must be closed. If the Inland Revenue doesn't succeed in getting the ruling overturned, the Government is widely expected to change the law to close the Eversden loophole but for the moment it still exists as a means of avoiding IHT.

At the moment the IHT threshold is only £250,000. (I say 'only' because with house prices the way they are these days, it's not difficult to achieve that threshold). Inheritance Tax is charged at 40% on any assets over and above £250,000 so if you die leaving a house worth, say, £500,000, the taxman can get his mitts on £100,000 of it. Unless you do a bit of tax planning!

Now, you may also know that you can give assets away and, if you survive for seven years, then those assets won't be liable for IHT. But it doesn't work if you give, say, your property away and then continue to live in it - it's known as a gift with reservation of benefit because you haven't really given it away outright.

With married couples, an estate left to a spouse is free of IHT so any tax problem usually arises when the second spouse dies – at which point the beneficiaries, usually the children, get clobbered because they have to sell up to find the money to pay the IHT bill. It was this situation that the Eversden case tried to avoid.

In the court case, a wife set up a Trust and put a property into it. The terms were that her husband had a life interest, i.e. he was entitled to use the property throughout his life.  In this instance, he actually died first so the use of the property ended up at the discretion of the Trustees, and the potential beneficiaries of the Trust – which happened to include the wife.

This particular set of circumstances raised the question: when the wife dies is her estate still liable for IHT because she was living in the property until her death?  The Inland Revenue felt that it was, but the answer was no, mainly because of the specific let-out where the original gift is between spouses.  Because the husband had a life interest in the Trust on which the house was originally settled by the wife, then the let-out was available. Her home was, therefore, not part of the estate so the Inland Revenue was not able to claim that IHT was due on it.

In other words, the judgement means that it is possible to give away your house without completely giving it away. 

If the law does get changed to close the loophole, there are a couple of other methods that can be used that the Inland Revenue doesn't seem to object to.

The first is the establishment of a discretionary Trust that comes into operation upon the death of first spouse ie: under the terms of his Will which specifically arranges for the Trust to receive assets from his estate up to the exemption limit of £250,000.  The surviving spouse is normally appointed as a beneficiary as well as Trustee and can therefore enjoy use of the assets whilst still alive.  Any assets in excess of £250,000 pass to the surviving spouse in the normal way - free of any IHT liability due to the married couple exemption.  On the death of the second spouse these assets can pass to chosen beneficiaries after deduction of her own exemption limit. It ensures that both spouses get to use their own exemption limits.

The second method entails selling your property to a Trust (making yourself the Trustee) whilst you continue to live in it. Since the Trust has no money, it gives you an IOU for the value of the house. Since you're in charge, you then pass the Trust over to the children who sit on the IOU until you die - at which point they call in the debt. The property now belongs to the children and, as it was held in a Trust, it is exempt from IHT on your estate (as long as you lived for seven years after giving it to the Trust, of course).

That's the theory anyway! As always these things are tremendously complicated and you need a lawyer well-versed in Trust matters to set one up properly if you own the sort of assets that are going to result in a big tax bill.

The easiest and simplest way to deal with possible IHT problems is to take out a life assurance policy that pays out enough to your beneficiaries to deal with the tax bill. These can be expensive depending the amount of assets you have but payouts from life assurance policies are tax-free and don't fall within the value of the estate so they're worth considering.

More: Life Insurance Basics