Recently I was consulted by a retired couple who wanted me to review their estate planning and consider opportunities for inheritance tax mitigation. The couple had two grown up daughters, with the youngest suffering from a long-term depressive disorder. Her condition meant that she was not sufficiently responsible to be given unfettered access to a large amount of money. The elder daughter was married and had young children. The younger daughter was divorced and also had young children.
The couple wanted their wealth to pass in equal shares to their two daughters following their death. They also wanted their grandchildren to eventually derive some financial benefit. However, they were worried about how the younger daughter would cope with an inheritance that would comfortably exceed £1 million They had previously executed Wills that they thought would provide a solution to this predicament. Their wealth would be left solely to their elder daughter (she had not been told of this) who would be trusted to pass money on to her sister and children as required.
“The trusts were intended to provide sustenance for both children and grandchildren so a long term investment strategy has been adopted. The potential IHT savings were significant”
I explained that they were transferring, albeit inadvertently, a significant responsibility to their elder daughter and that it was an unfair burden to pass on without prior warning. Furthermore, the possible risks of this approach had not been thought through sufficiently.
Firstly, even the best family relationships can come under pressure. In this instance, the elder sister could be required to supervise her sister’s ‘inheritance’ for 40 years and a lot can happen in a relationship over that timeframe.
More significantly, the younger daughter’s notional inheritance would be an asset of the elder daughter. How would the elder daughter feel if her relationship with her husband broke down, they split, and he walked away with a 50 per cent share of her sister’s £1m inheritance? She may feel she had let down not only her sister and her children but the expressed wishes of her parents.
What if the elder daughter was sued as a result of an uninsured accident or other event? All of the money could have been taken from her.
What if the elder daughter died? Assuming ‘personal’ assets alone utilised the Inheritance Tax (IHT) nil rate band, 40 per cent of her sister’s inheritance could have disappeared in death duties. Bearing in mind that IHT would also have been paid on her parents’ Estate, the effective marginal tax rate on capital finally passed to the younger sister would be 64 per cent.
Not surprisingly, the parents were shocked when I explained to them the possible implications of the existing Will.
The first job was to consider the alternative options and then refer the matter to a specialist solicitor to stress test the strategy and draft the appropriate documents. The Wills were subsequently changed so that the younger daughter’s share of the inheritance would pass to a discretionary trust and a letter of wishes would guide the trustees.
The elder daughter was nominated as a trustee of the new arrangement. She would, therefore, participate in looking after the financial needs of her sister as first intended. However, because a trust is a separate legal entity, there could be no call upon it from her future creditors and the money would not be subject to IHT twice whilst passing from parents to daughter.
In terms of the couple reducing their IHT liability, the first step was to assess whether it was feasible that some capital be gifted directly or passed to trust now.
Since both parents were in their eighties, it was important to establish what money they might need in the future and potential nursing or care costs. A calculation was made and the costs for the best care homes in their locality would be compared to the income flow from occupational and State pensions. The assessment was based on an immediate requirement for residential care with the cost of such care rising at the rate of 10 per cent per annum over a total duration of 20 years. It is important to plan for the worst case scenario, that way there are unlikely to be any unpleasant shocks. The difference between cumulative net pension income and cumulative care costs identified the funding gap, and a discounted cashflow calculation using a modest return assumption was used to calculate the capital that should be retained.
The balance of capital was therefore available to gift and a decision was made to immediately create a series (more tax efficient for larger amounts) of trusts funded separately by each parent. They were able to each gift an amount equivalent to the IHT nil rate band and hope to survive seven years so that the gift became exempt. The trusts were intended to provide sustenance for both children and grandchildren so a long term investment strategy has been adopted. The potential IHT savings were significant. The accompanying chart provides an example.
To conclude, estate and tax planning is important if hard earned wealth is to be protected for the benefit of those that matter most to you.