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Tax planning from beyond the grave: The two year rule

21st October 2009

As life expectancy increases (it is now over 77 for men and 81 for women) many people are inheriting wealth at a time when they themselves are comparatively well off. On receiving an inheritance their first thought may be to pass on some or all of their increased wealth to their own children. There is, of course, nothing to stop them doing so. Unfortunately, such gifts can give rise to unnecessary inheritance tax if they are not properly structured. This may arise where the person passing on their inheritance dies within seven years of doing so. In that eventuality an additional tax charge of 40% of the value of the gift could occur. Effectively this could amount to double taxation since the amount in question would have been subject to inheritance tax on the first death.

Passing on wealth to the next generation

Somewhat generously the law provides a way of avoiding this double charge. A beneficiary has a period of two years from the death of the person they are inheriting from to make a formal variation of his or her entitlement. This applies both to someone inheriting under a Will and to someone inheriting under the intestacy rules - where someone has died without a Will. For the purposes of inheritance tax the variation will be treated as if it had been contained in the Will of the person who had died. The advantage is that the beneficiary who has passed on their inheritance is not treated as having made a gift. Even if he or she dies within seven years of the variation no additional inheritance tax will be paid on the gift.

This therefore provides an ideal way for a son who has received £200,000 from his mother's estate to pass on, for example, £100,000 to his own children.

Saving inheritance tax

This mechanism is not limited to outright gifts to other individuals but is useful in other situations. Frequently a beneficiary will want to have access to the entire sum they have received but would rather not pay inheritance tax on that sum on their death. This can be achieved by the beneficiary varying the Will to set up a trust. The beneficiary under the Will can still have access to the money which they have diverted to the trust but that money will not be subject to inheritance tax when they die. In this way 40% of the value of the money in the trust (including any growth on that money), during the remaining lifetime of the beneficiary, will be saved from inheritance tax.

Protection from care home fees

The legislation can also help protect against care home fees. Often a Will leaves an entire estate to the surviving widow or widower. He or she may be concerned that their total estate, including the estate inherited from their deceased spouse, may have to be used to pay care home fees. In this situation a deed of variation may be used to set up a trust to protect the estate of the first spouse to die from ever being used for care home fees. The surviving spouse can still have the benefit of the estate of the first spouse to die, including living in a property which was owned or part-owned by them, but the assets in the trust will not have to be used for care home fees.

Farms and businesses - use the relief

Variations may also be used to take full advantage of inheritance tax relief on businesses and farms. Businesses, including shares in limited companies and agricultural property, often qualify for complete relief from inheritance tax. If such assets are left to a spouse it is frequently the case that those assets will be sold and that inheritance tax will be paid on the surviving spouse's eventual death, in many cases leading to large and unnecessary tax bills. To avoid this possibility the surviving spouse can instead vary the Will to divert the assets to a trust; the spouse can continue to benefit from those assets but no inheritance tax will be payable on them on their own death.

Previously widowed?

Another good use of the legislation occurs in the cases of spouses who were widowed but subsequently remarried. There is an opportunity for them to take advantage of an additional tax free amount (currently£325,000) in respect of their previously deceased spouse. Many such spouses die without having altered their wills to use this additional relief and miss out on saving up to £130,000. Fortunately the two year rule allows their own surviving spouse to rectify this without suffering any hardship themselves by varying the will.

Changing trusts

Bear in mind that many trusts in wills may also be altered within two years of death to maximise inheritance tax relief or restructure the trusts in a way which is more appropriate at the time, including bringing them to an end.

Don’t miss out!

While the terms of a Will may appear to be set in stone this is not the case so far as tax planning is concerned. When someone has died it is always worth a beneficiary taking legal advice on the opportunities a variation may offer for protecting their own estate.

For further information regarding probate, estate administration or estate planning, please contact David Whitworth at Mowbray Woodwards Solicitors on 01225 485700.

For further information on any of our news stories,
please contact Katie Vander Woerd.