Three ways Deeds of Variation can save tax for your clients
Deeds of Variation allow your client’s Will to be varied within two years of their death with the variation being read back into the Will for inheritance tax and capital gains tax purposes. They can be a vital tool in remedying defective Wills and in enabling disputes to be resolved in a tax efficient way. Deeds of Variation can also be used to make inheritance tax savings for clients and we look at three ways that this can be achieved.
Discretionary trusts for adult children
Many straightforward Wills provide that on the death of the survivor of a couple their joint estate should be divided equally among their children. This is adequate in many situations, but for larger estates it is worth considering a deed of variation to replace the outright gifts with a discretionary trust for each child and their respective families.
If the children have taxable estates of their own, giving them an absolute interest in their parent’s estate will add to this tax liability. In addition, if any of the children die prematurely their share of the estate may pass outside of the blood family to a spouse or partner. By comparison, if the deed of variation inserts discretionary trusts into the Will, on the death of an adult child there is no entitlement to any underlying capital so this is preserved for the surviving family. There is also no charge to inheritance tax.
Discretionary trusts pay inheritance tax on every ten year anniversary of their creation and when capital leaves the trust. The tax payable is currently at a maximum rate of 6%. If the appropriate elections are made in the Deed of Variation the deceased will be regarded as creating the trust in their Will. This means there is no inheritance tax payable on creation of the trust or if the children who give up their absolute entitlement do not survive seven years. Similarly there is no capital gains tax liability on creating the trust as the trustees will be deemed to take the trust assets at probate value, although the children will be regarded as the settlor of the trusts for other capital gains tax purposes.
Example:
The potential inheritance tax saving can be substantial. For example, John’s Will leaves his £3 million estate equally between his two children. His divorced son Harry varies his entitlement to place his share into a discretionary trust for himself and his family. The trust pays inheritance tax every ten years and Harry and his family have the benefit of the trust funds through loans. The trust continues for 20 years at which point Harry dies. Assuming a static value, and using 2023 rates and allowances, the trust will have paid inheritance tax periodic charges of approximately £141,000. If Harry had not entered into the deed of variation the inheritance tax payable on his death would be approximately £600,000 (assuming assets in Harry’s personal estate are worth at least as much as the IHT nil-rate band).
Putting assets rising quickly in value outside of the surviving spouse’s estate
A deed of variation can be a useful tool for passing on assets to the next generation that have growth potential with no immediate inheritance tax bill.
For example, when Alan dies he owns some land with potential development value. It is valued at £180,000 at the date of death but during the course of the administration of the estate, planning permission is obtained and the value increases to £1.5 million. If this increase takes place within two years of Alan’s death, his widow can provide (in a deed of variation) for a specific legacy to be inserted into Alan’s Will leaving the land to their children. The probate value of the land is within Alan’s nil rate band so the children will receive an asset worth much more than the nil rate band without any inheritance tax to pay.
The children will have to pay capital gains tax on the increase in value over the probate value when the land is sold, but this will be at a much lower rate than inheritance tax if current rates apply.
If Alan’s widow wishes to retain the possibility of benefitting from the land (but to put the asset outside of her estate for tax purposes), the gift inserted into the Will could be to a discretionary trust of which she and the children could be beneficiaries.
Excluded property trusts
Your clients may occasionally inherit under the Will of a testator who is not domiciled in, or deemed domiciled, in the United Kingdom. If your client is domiciled in the UK, the inherited property (even if it is outside the UK), will form part of their assets and will be subject to inheritance tax on their death. If all the assets are foreign, your client could vary the Will to create a discretionary trust of their share of the estate. Your client could be a beneficiary of the trust. For inheritance tax purposes the settlor of the trust is the foreign domiciled settlor which means that the trust assets are “excluded property” as they were during the deceased’s lifetime. As excluded property, the trust assets are not subject to inheritance tax, meaning there are no periodic charges and no inheritance tax charge on the assets on your client’s death.
The individual circumstances of the client would have to be taken into account before such a variation is carried out but potentially significant amounts of inheritance tax might be saved.