Tax planning post death: Opportunities and pitfalls By Emma Chamberlain

Feature

posted 1 Jul 2000 in Volume 5 Issue 5

Tax planning post death: Opportunities and pitfalls
By Emma Chamberlain

Deeds of variation (or deeds of family arrangement as they used to be called), are well-known as a way of mitigating inheritance tax. Disclaimers of an interest under a will or intestacy are less common but can be equally useful planning devices. And for the more adventurous there is the possibility of using what are called two year discretionary trusts in their wills. All these options are worth considering but there are a surprising number of pitfalls which can catch out the busy practitioner. This article attempts to summarise the basic law on post death tax planning and outline some of the opportunities and pitfalls.

It is also worth remembering that post-death alterations are relevant not only in relation to deeds of variation and disclaimers, but also in respect of certain orders under the Inheritance (Provision for Family and Dependants) Act 1975 which are automatically given retrospective effect for inheritance tax purposes under section 146 IHTA.

Similarly the right of the surviving spouse to capitalise the life interest on intestacy, which could involve the termination of a surviving spouse's interest in possession and thus potential inheritance tax consequences is dealt with under section 145. This provides for inheritance tax purposes that the capitalised value is something the surviving spouse was entitled to as from death rather than a life interest. (There is no equivalent provision for capital gains tax purposes.)

Deeds of variation - the election

Effectively section 142 IHTA 1984 and section 62 TCGA 1992 allow a two year breathing space in which beneficiaries of the will can decide whether to rewrite the provisions of the deceased's will or the passing of property on intestacy in a more tax effective way. For both inheritance tax and capital gains tax purposes an election can be made to write the gift back into the will as if it was made by the deceased. But in property law terms, the gift is still made by the beneficiary under the will. The deeming for tax purposes is just a fiction.

Section 142 operates where, within a period of 2 years after the individual's death, the destination of any of the assets of his estate passing by will, intestacy or otherwise is varied or altered or the benefits are disclaimed by an instrument in writing made by the original beneficiary and (except in the case of disclaimer) an election is made within 6 months of the variation (whether or not the election is made more than two years after death). There is no discretion for the Revenue to extend the two year period for making deeds of variation or disclaimers. In very rare circumstances they may apparently extend the time limits for making an election but the author has never known them do so in practice.

If an appropriate tax election is made, the variation is deemed to have been effected by the deceased or the property to pass as if the disclaimed benefit had never been conferred. An election back for inheritance tax purposes applies for all inheritance tax purposes. Thus someone who varies a will and can still benefit from the varied gift has not reserved a benefit since the gift is treated as being made by the deceased. The position is slightly different for capital gains tax purposes.

There is no obligation to elect and one can choose to elect for inheritance tax purposes but not for capital gains tax purposes or vice versa.

The personal representatives do not have to be a party to the deed of variation, only to the election and only then if additional inheritance tax (as opposed to capital gains tax) is payable.

Personal representatives by definition cannot be party to a disclaimer and since no election can be made under a disclaimer anyway have no control over any additional inheritance tax which may become payable.

It is possible to elect within the deed of variation itself which is common or to have separate elections outside the deed. Any notice of election must refer to the appropriate statutory provisions and must be sent to the CTO for inheritance tax purposes and to the Inspector of Taxes dealing with the estate for capital gains tax purposes.

For inheritance tax purposes whether or not to elect for inheritance tax is usually fairly straightforward. If the purpose of the variation is to use a nil rate band or spouse exemption, clearly an election will need to be made.

For capital gains tax purposes the position is more complex. If the administration has been completed the varying party makes a disposal of the asset at market value. If this has increased from probate cost he will make a chargeable gain. An election will be desirable unless the gain is covered by his annual exemption, losses or some other relief such as PPR.

If the administration is incomplete the varying party will make a disposal of a chose in action being the right to secure due administration. The base value of such right is nil. Therefore a capital gains tax election when the administration is not complete is likely to be necessary in almost all cases.

A major difference from the inheritance tax position is that section 62 (6)(b) clearly states that the deeming of the variation applies only for the purposes of 'this section.' By contrast section 142 (1) extends the fiction for all purposes of the Act. Following the House of Lords' position in Marshall -v- Kerr, it is the beneficiary not the deceased testator for capital gains tax purposes who is treated as the settlor of any continuing trusts. Thus where the beneficiary making the variation is also a beneficiary of the trust, then under section 77 future trust gains are taxable on the beneficiary as settlor not on the trustees. The capital gains tax election is only effective to provide that the property is treated as being acquired at market value at date of death.

Pitfalls

1. You can only vary once for tax purposes

The Revenue does not accept it is possible to execute more than one deed of variation over the same property (see the rather unsatisfactory case of Russell & Another -v- IRC [ 1988] STC195) for tax purposes although the property consequences would stand. (Thus there is nothing to stop deceased giving to A giving property to B who gives it to C within two years- all such gifts remain perfectly valid. But for tax purposes, one cannot elect that the gift by B to C is a gift by the deceased to C.)

However, there can be a number of variations at different times within the 2 year period over the same estate provided each variation deals with separate property. Thus A can give up one half of his interest in the residuary estate under one deed and later give up the balance of the estate in another deed. When drafting deeds it may be worth remembering this in case another variation is required later.

Sometimes the deed of variation goes wrong - e.g. a legacy is made free of tax instead of subject to tax and inheritance tax ends up being payable. In these circumstances practitioners sometimes try to do another deed of variation. It will be rejected by the CTO. A better approach may be to apply for rectification of the original deed but a court application will be necessary before the CTO accepts it.

2. Who signs the deed?

Only the person who would benefit under the original dispositions of the will or intestacy needs to sign the deed of variation and they can do so at any time in the two year period, even if the grant of probate has not been obtained. Contrary to popular belief there is no need for other beneficiaries of the will to sign even if part of the residuary estate is being varied and there is no need to wait until probate is proven..

3. Capacity

One major disadvantage of variations and disclaimers is that people under any incapacity such as a minor, or someone mentally incapable cannot make a deed of variation or disclaimer. Contingent beneficiaries under trusts cannot vary their interests.

The issue of mental incapacity sometimes arises where the first spouse dies and the second spouse becomes or is mentally incapacitated, but has executed an enduring power of attorney. The attorney cannot execute a valid deed of variation on behalf of the second spouse without the sanction of the court, a point that the CTO is known to take.

A minor cannot be a donor party to a deed of variation, although obviously can benefit. However, provided the minor's interest under the will or intestacy is not affected a variation can go ahead. For example if a will creates a trust in which the remainder interest belongs to a minor there is no objection to any prior interest being the subject of the deed of variation.

However, a deed of variation cannot be used to destroy one interest of the minor beneficiary and create a different interest even if the minor will benefit overall. If any pre-existing interests of a minor are altered, then the variation can only go ahead with the approval of the court.

4. Insolvency

A deed of variation redirecting inherited assets will not escape the insolvency provisions as a transaction at an undervalue and could be set aside in the normal circumstances of any gift made by the insolvent living beneficiary. Similarly the beneficiary who deprives himself of an interest in an estate by deed of variation for the purposes of claiming state benefits will be treated in the same way as if he had made a lifetime gift.

5. What property to vary?

Section 142 can only apply to property comprised in a person s estate immediately before his death. Excluded property is within this definition (Section 142(5)). It will also include jointly owned property but not gift with reservation property or property in which the deceased had a life interest at the date of death. Whilst the CTO has confirmed a deceased's joint tenant's interest passing by the survivorship can be redirected by deed of variation, it is not thought possible for an effective disclaimer to be made by a surviving joint tenant.

6. In writing

Whether a variation or a disclaimer, the instrument has to be in writing. This does not necessarily mean by deed but a variation can only receive the favourable tax treatment if effective in property terms, which means that the variation has to be binding and enforceable. To obtain the tax advantages there must be no extraneous consideration and therefore a deed is almost always used.

7. Trusts

Variations are possible even if the beneficiary only has a life interest. A variation in breach of trust cannot be accepted and therefore a discretionary trust set up in the will cannot be varied unless there is some limitation to the class and all potential beneficiaries can be brought in, which is unlikely. If the will sets up a fixed interest

Will trust and all possible beneficiaries can be got in and agree then the variation over the whole will trust may be possible.

Obviously there must be no minors, unborn children or contingent interests. It is perfectly possible however, for a person with a life interest to vary that life interest alone although then the beneficiaries under the deed of variation will only take an interest pur autre vie. The life tenant should vary the life interest in favour of specified beneficiaries but these do not have to be the remaindermen- the remainder gift will not automatically come into effect on the execution of the variation if it is a contingent interest.

The will or intestacy can be varied into a trust. Either a separate trust can be set up in advance (after or before the testator's death) and then the variation made into the trust, or the variation itself can set out the trust in a schedule. Perpetuity and accumulation periods should be dated from the date of death. If a variation into a new discretionary trust is made then the ten year anniversary runs from the date of death not the date of the trust.

8. Consideration

Section 142(1) does not apply to a variation or disclaimer which is made for any consideration in money or money's worth. The same is true for capital gains tax purposes and therefore anything other than the consideration of another beneficiary entering into a variation is not acceptable. Therefore the donor to the deed of variation should pay the legal costs not the personal representatives or donee and there should be no understanding that the beneficiary will give the property back to the donor at any later date.

Some uses of variations and disclaimers

1. Using nil rate band

Variations are often used to rewrite the will so that the nil rate band of the deceased person is utilised. For example, where the will leaves everything outright to the surviving spouse he or she may execute a deed of variation varying up to the unused nil rate band in favour of children or on discretionary trust. Variations can also be used to maximise reliefs such as BPR and APR.

2. Tax free/subject to tax legacies

Deeds of variation may be used to convert tax free legacies into subject to tax free legacies and thus avoids the grossing up provisions in section 38 IHTA etc.

3. Using spouse exemption

Where a testator has made gifts in excess of the nil rate band to a chargeable party such as adult children or has died intestate these chargeable parties could redirect/vary the will in favour of the surviving spouse. The surviving spouse should not then immediately make PETS back to the children. Otherwise the Revenue could attack such an arrangement under the Ramsey doctrine or on the basis that the variation was for consideration in money's worth. There must be no written or verbal agreement, arrangement or understanding as to any onward gifts from the surviving spouse to the children.

4. Domicile

If the testator is not domiciled in the UK and has left his estate outright to UK domiciled beneficiaries, that beneficiary could vary the will of the foreign domiciliary to set up an excluded property settlement for inheritance tax purposes. (For capital gains tax purposes the House of Lords held in Marshall -v- Kerr 67TC56 that the donor is the person making the variation for anything other than section 62 purposes.)

9. Passing on increases in value

Deeds of variation can be used to pass on the benefit of increases in the value of the deceased's estate within the 2 year period. For example H dies leaving his entire estate worth £500,000 to widow W. Within 18 months it has increased in value to £700,000. The increase in value belongs to W but she does not need the extra £200,000. W could make a deed of variation under which she varied H's Will to give herself a pecuniary legacy of £500,000 leaving the residue to the children. She would make an election under section 142. The inheritance tax value of the estate remains at £500,000 and under section 38 all of this £500,000 would be attributed to the exempt specific gift to the widow. Thus the estate retains full spousal exemption but the growth is being passed tax free to the next generation.

10. Generation skipping

Deeds of variation can be used for generation skipping - eg an adult child inherits from a parent and makes a deed of variation in favour of his own children. There is no immediate inheritance tax saving in the deceased parent's estate, but in the longer term the varied assets have been taken out of the inheritance tax net of the child.

11. The family home

Deeds of variation can be used in relation to the family home - for example if H leaves his interest in the home outright to W she can vary this to give the children an interest. The reservation of benefit provisions would not apply even if W occupies the whole property. Care is needed if the husband's share in the house is put into a nil rate band discretionary trust from which W can benefit - the Revenue may well argue she has an interest in possession in such trust if she occupies the home, even if she also owns a share in it. Further steps must be taken to prevent a tax charge on her death.

12. Double taxation relief

Deeds of variation can be used to utilise double taxation relief - for example where there is tax in the foreign country payable on assets passing to the spouse it may be worth redirecting such assets to the children. The foreign tax can then be used as a credit against any UK tax liability but the assets pass down to the next generation. This is obviously only a worthwhile exercise if the foreign tax charge is at least as much as the UK tax charge would be on the second death.

13. Changes in value

Variations can be useful where quoted shares have fallen in value after the 12 month period from death. Revaluation relief is not possible after the 12 month period and in that case a deed of variation can be made leaving the shares to an exempt party such as a surviving spouse or charity.

14. Double death variations

The personal representatives could stand in the shoes of a deceased beneficiary, if the beneficiary died after the testator, for the purposes of effecting a deed of variation or making a disclaimer. This is often referred to as double death variations. For example, suppose husband leaves everything to wife who then dies 6 months later. W leaves all the property to the children. The combined estates exceed the nil rate band of the wife and the husband's nil rate band has been wasted.

Even if the beneficiaries of the variation are those who would have taken in the wife's estate in any event, so that there is no overall movement in the beneficial interests, it does not appear the CTO would attack the personal representatives of the wife varying the husband's will, the aim being to leave his nil rate band to the children. In these cases the deed of variation should be between the personal representatives and the relevant beneficiaries of the second estate as well as the personal representatives of the first estate. The second estate should remain solvent after such a variation and a recital to this effect should be put in the deed of variation.

Disclaimers compared with deeds of variation

In the case of a variation the beneficiary redirects the dispositions to whomever he chooses. In a case of a disclaimer, the beneficiary cannot choose whom he wants to benefit and the disclaimer merely accelerates the subsequent interest. For example a disclaimed pecuniary legacy may fall into residue. A disclaimer is simply a refusal to take an interest or property without any control over the alternative destination of such interest or property. Therefore it is not possible to disclaim after the interest has been accepted and any act of acceptance or receipt of benefit will prevent a subsequent disclaimer.

It appears that the whole interest has to be disclaimed unless the will authorises partial disclaimers. The Capital Taxes Office has confirmed that a partial disclaimer is permissible if the will includes a power to this effect (see Tolleys Practical Tax 28th June 1989 page 102).

There is nothing to stop a will being drafted so as to set out who will obtain property in the event of its disclaimer (see Guthrie v Walrond [1883] 22 Ch 573). Assume, for instance, that property is to be left by will to a surviving spouse but the testator is aware that when the time comes it may be desirable for that spouse to disclaim it. The will could be drafted to provide that in the event of such a disclaimer the property should pass to the grandchildren of the testator on accumulation and maintenance trusts. In this way the vagaries of the general law on disclaimers can be avoided. Further, a provision enabling the relevant beneficiary to disclaim all 'or any part' of the property in favour of the grandchildren will be equally effective and thereby circumvent one of the main restrictions on the use of instruments of disclaimer.

In the case of the variation it does not matter that the beneficiary has, prior to the variation, received a benefit but in a case of a disclaimer it is a requirement that he has prior to the disclaimer received no benefit. One advantage of disclaimers is that the income tax disadvantages and in particular section 660B do not apply. The effect of the disclaimer is to render the disclaimed interest void ab initio and there is no taxation of the pre disclaimer income on the disclaiming beneficiary. Neither is it a Part XV settlement. This can be useful if, as a result of the disclaimer, the donor's minor children benefit.

The disclaimer must be consideration free unless the consideration is another variation or disclaimer.

It should be noted that the 1989 Finance Bill introduced provisions to abolish the ability to make tax privileged deeds of variation and discretionary wills (provisions which were eventually dropped by the Government) but the ability to make tax privileged disclaimers was not stopped.

Some care is needed as to the devolution of assets if an interest or property is disclaimed. For example where a life interest is disclaimed and there follows a vested absolute remainder interest, then that remainder will take immediate effect i.e. it is accelerated.

As with deeds of variation only those who have capacity to vary can disclaim. However, there is no need to make an election since the relief of both capital gains tax and inheritance tax is mandatory.

In general terms, deeds of variation will be safer than disclaimers but in limited circumstances disclaimers may be more beneficial.

Obviously however, it is always preferable that the deceased should have a well drafted will rather than relying on the ability of any beneficiary to make variations or disclaimers. The law may have changed, the income tax and capital gains tax consequences are unlikely to be as good and (perhaps most likely) the beneficiary may not be able or willing to make the deed of variation or disclaimer.

Will trusts

Where someone cannot decide what should be the ultimate destination of his estate or perhaps it is doubtful whether property will qualify for full business property relief or the estate is particularly complicated, advantage can be taken of s144 IHTA. This section allows distributions to be made within two years of the death without any charge to inheritance tax out of assets settled on discretionary trust by the will.

The individual thus makes a will settling his residuary estate on discretionary trust and specifying a range of beneficiaries. The trustees then within two years of the death act on a letter of wishes left by the deceased. The distribution by the trustees is treated for tax purposes as being made by the deceased.

Thus section 144 has the same effect for inheritance tax purposes as a variation under s142 although it is left to the discretion of the trustees rather than the person who actually receives the gift. It also has some advantages over a s142 variation which cannot be done unless the person has full capacity and is an adult. Under s144 no such obstacle exists. For income tax purposes a s144 appointment also enables the parent not to be treated as a settlor for income tax purposes.

The two main disadvantages of section 144 are cash flow and capital gains tax. As far as cash flow is concerned, unless the executors appoint in favour of the spouse before grant, inheritance tax has to be paid in order for the grant to be obtained. Further, in order to avoid the problems in Frankland -v- IRC [1996] STC 735 there should be no appointment within three months' of the deceased's death. See also Loveday deceased -v- IRC 1997 STC 321.

For capital gains tax purposes, distributions/disposals to a beneficiary within the two year period will not be eligible for CGT holdover relief because such distributions are exempt from IHT. If the property to be appointed out has shown a gain since the date of death this may cause problems. However, if the administration of the estate is not completed and there is power for the trustees to appoint before this date then the capital gains tax problem can be avoided. The Revenue takes the view that where, in exercise of their powers, the trustees appoint to a beneficiary qua legatee the trust assets are never acquired by the trustees at all for capital gains tax purposes because the acquisition of the assets in question is that of the appointee. The latter acquires at the personal representatives base cost. A recital in the deed should be put in to the effect that the administration has not been completed.

Summary

The tax planning options after someone has died let alone when planning the will are numerous. But it is worth getting the basics right before embarking on the planning!

Emma Chamberlain is a Barrister at 8 Gray's Inn Square and can be contacted on 0207 242 3529