A big part of making inheritance plans for your loved ones, is ensuring that the property and money you are passing on will not be eroded by tax bills. Inheritance tax in particular can have a significant effect, especially if your arrangements do not make the most of tax-saving measures that are available.

The old saying goes that nothing is certain except death and taxes, but actually, inheritance tax – something which combines both – is not always as inevitable as you might think. When you die, your estate is assessed for inheritance tax. In general, if the value of your estate is under a certain amount, there will be no tax payable. Also, taking advantage of tax-saving measures allowed by the inheritance tax regime can significantly reduce the amount your estate has to pay – sometimes to zero.

Inheritance tax charges in life

Most people are aware that inheritance tax is assessed upon death, but it is less well-known that payments and transfers in life can also be subject to inheritance tax in some situations.

Some lifetime transfers, such putting money or property into certain trusts, can cause an immediate inheritance tax charge. More commonly however, a lifetime transfer will be treated as a ‘potentially exempt transfer’, which will not be considered for inheritance tax unless you die within 7 years of making it.

Our factsheet on ‘Reducing your Inheritance Tax’ gives more background on how inheritance tax works and provides guidance on arrangements you can make to reduce your bill.

A recent case highlighted the importance of considering lifetime transfers in your plans and also demonstrated several other quirks of the inheritance tax system. These included:

  • Gifts with a reservation of benefits
  • Trusts for disabled persons
  • The ways in which trusts are assessed for inheritance tax

Rogge v Rogge [2019] EWHC 1949 (Ch)

The case arose following Olaf and Kristina Rogge’s attempts to make provision for their children and, in particular, their son Stefan. Stefan had suffered a serious brain injury in 2009, when he was 18, leaving him with severe disabilities. In 2011, Olaf and Kristina decided to purchase a house in the country which would serve as a retirement home for them, as well as providing suitable living arrangements for Stefan, and space which the rest of the family could enjoy.

Olaf and Kristina set up a trust, appointing themselves and two of Stefan’s siblings as trustees. Stefan was named as the principal beneficiary of the trust. Any children or grandchildren etc. he might go on to have were also included as possible beneficiaries, as were Stefan’s siblings. The trustees were given powers to choose how and which beneficiaries should benefit, making it a kind of discretionary trust. For more information on discretionary trusts, as well as other types, have a look at our relevant factsheets.

Olaf transferred £4.1 million into the trust for the purchase of the house. Over the next 5 years, the trust paid out nearly £13 million in construction costs and work to the house. However, Olaf and Kristina later became aware that the way in which they had arranged their affairs would not have the tax effects they desired.

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The issues

The trust arrangement and transfers Olaf and Kristina had made brought up two main issues:

  1. Olaf and Kristina were living in the house. This meant that although the trust had actually purchased the house, using the £4.1 million from Olaf, it constituted a ‘gift with a reservation of benefits’.
  2. The payments out of the trust, for things which were not for Stefan’s benefit, meant Stefan might be facing a high inheritance tax bill on his estate. This was due to the nature of the trust which had been set up.

These are explained in more detail below.

Gifts with a reservation of benefits

The inheritance tax regime has rules to prevent people from giving assets away and still enjoying the benefit of those assets. This is to avoid situations where someone could remove an asset from their estate (and not have it assessed for inheritance tax on their death) but still have use or enjoyment of that asset in their lifetime.

In Olaf and Christina’s case, the £4.1 million was a gift to the trust. The trust used this to buy the house which Olaf and Christina then occupied. By living in the house, they were enjoying a benefit from it.

There are many complicated rules surrounding gifts with a reservation of benefit. In brief, however, to work out whether a benefit is being reserved the rules look at whether the intended recipient of the gift:

  • Began enjoying or possessing the asset at any point; and
  • Enjoyed or possessed the asset to the exclusion, or virtual exclusion, of everyone else.

It could not have been said that Stefan enjoyed the house to the exclusion of his parents; they lived there as well. As such, it was a clear gift with a reservation of benefit. If this situation remained unchanged, it would mean that the house would be treated as part of Olaf’s estate upon his death, and would likely incur a large amount of inheritance tax.

This is a more subtle example of how a transfer completed in life can still attract inheritance tax consequences.

Taxing disabled person’s trusts and discretionary trusts

Due to Stefan’s condition, the trust in the case was set up to take advantage of the rules on trusts for disabled persons. A disabled person’s trust receives favourable inheritance tax treatment as long as certain criteria are met and adhered to. They offer a way for parents of disabled people to provide for their welfare without incurring large amounts of tax.

As mentioned above, the trust Olaf and Kristina created also had a discretionary element. Ordinarily, any payments into this trust would have incurred an immediate inheritance tax charge, but because the trust was a disabled person’s trust, these transfers were treated as ‘potentially exempt transfers’ (as explained above) instead.

The trust’s status as a disabled person trust also gave other inheritance tax benefits such as:

  • No regular inheritance tax charges on the trust assets (normally incurred on discretionary trusts every 10-year anniversary of the creation of the trust).
  • No exit charges. These are another form of lifetime inheritance tax charge, occurring when assets leave a discretionary trust (as well as certain other kinds of trust).

However, a disabled person’s trust also has rules relating to the purpose of any transfers out of it. Any payments out of the trust to, or for the benefit of, anyone except the disabled person, are treated as being lifetime transfers made by the disabled person.

In Olaf and Kristina’s case, they had added their other children as beneficiaries of the trust. As a consequence, any payments from the trust to those other children would be treated as ‘potentially exempt transfers’ made by Stefan. This could lead to a huge inheritance tax bill for Stefan’s estate if he were to die within 7 years of these transfers, especially given the amounts that the trust had already spent.

Finally, a disabled person’s trust treats the assets in the trust as belonging to the disabled person’s estate upon their death. This is in contrast to common discretionary trusts where a beneficiary is only treated as owning trust assets if the trustees have advanced them to that beneficiary. In Stefan’s situation, this could massively increase his estate, for inheritance tax purposes, at the time of his death.

Why it is important to seek specialist advice

Making sure that your inheritance arrangements will have the effects that you intend is crucial, particularly when the welfare of your loved ones is at stake. There is no substitute for clearly setting out your intentions to a specialist in inheritance law and tax planning, and obtaining their advice.

For Olaf and Kristina, the unintentional effects of their arrangements could have been very costly – greatly increasing the inheritance tax they might pay and reducing the value they could pass on to Stefan and their other children. At the same time, it they would pass a potentially hefty tax burden onto Stefan himself.

They requested that the court make an order to effectively ‘undo’ the payments they had made, based on a strict legal principle regarding mistaken actions. The court agreed to make such an order.

Although disaster was averted for Olaf, Kristina, and their family, this may not be an option where the circumstances are different. In any event, the matter undoubtedly involved expensive and lengthy legal proceedings for Olaf and Kristina.

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