Life Interest Trusts, Second Marriages and the Inheritance Tax Trap

11th September 2007 

A fact of modern life in Britain is that many marriages end in divorce and that many people marry for a second, third time, or more.

Wherever there is a second or third marriage and the parties to the marriage have children from a previous marriage there is good reason to create a Life Interest Trust at least in respect of any matrimonial home, which is usually the main asset of the married couple.

Using this type of trust, steps are taken to ensure that the matrimonial home is held as joint tenants-in-common (usually 50% shares each) and Wills are made to the effect that the surviving spouse will be able to reside in the share of the matrimonial home owned by the deceased spouse for the rest of their life (until re-marriage) and thereafter the share of the deceased spouse will fall into the hands of the children of the first spouse to die. Usually there would also be provision for the surviving spouse to move to a new property on the same Trust terms.

This is generally seen as a fair settlement of matters as reasonable housing provision is made for the surviving spouse and the children of the deceased spouse have a remainder interest in the property which will usually be realised in a relatively short time, unless their parent married a much younger new spouse.

There are, however, Inheritance Tax (IHT) repercussions from such a Trust arrangement which are not always fully understood. Furthermore, despite widespread changes to Trust taxation as a result of the Finance Act 2006, the taxation of life interest trusts as created by Wills did not essentially change.

In simple terms, the IHT situation of such cases is that on the death of the first spouse, the gift of the life interest in the deceased's share of the property to the surviving spouse is treated, not surprisingly as a tax-free gift due to the spouse exemption.

However, on the death of the surviving spouse, their interest in the life interest trust is treated as part of their taxable estate even though the beneficiaries of the trust after their death will be the beneficiaries named in the Will of the first spouse to die.

As an example, we can assume a situation where a wife of a second marriage and is given a Life Interest Trust in a property owned by her deceased husband worth £300,000. The surviving wife also has assets in her own name worth £300,000.

Assuming all things being equal and the wife dies during the current tax year (2007/8) during which the nil rate bands is £300,000.00 (£312,000.00 - 2008/9), the wife's estate will be due to pay £120,000 tax.

This has been calculated as follows:-

Life interest in Trust Property - £300,000
Cash asset of her own - £300,000

Total - £600,000 less £300,000 nil-rate band (2007/8) =

£300,000 x 40% inheritance tax = £120,000 tax.

One half of the tax representing one-half of the value of the total estate monies will be payable by the trustees of the Life Interest Trust and the remaining one-half by the executors of the wife's estate.

If the balances of the trust monies go to the children of the previously deceased husband then the beneficiaries of the deceased wife will just receive the cash assets of £300,000 less £60,000 tax.

The important note to realise is that if under the legislation contained under the Trustee Act 2006, the original life Trust had been set up as a Flexible Discretionary Trust with the surviving wife (in our example) being one of the discretionary beneficiaries, then in our example set out above no inheritance tax would have been payable.

This is due to the fact that the value of the discretionary trust would not be treated as part of the surviving wife's estate and as such the cash assets of the surviving assets in the sum of £300,000 would just have fallen within the nil-rate band and no inheritance tax would be payable.

As ever, each case must be treated on its merits but the tax implications must be considered and appropriate advice from a specialist tax professional obtained. It is still possible to IHT with appropriate planning.

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