Pilot & Spousal Bypass Trusts

What do I do with my death in service benefit?  Why waste 40% of it?

In today’s sophisticated financial market, most people have death-in-service benefits through their employment or death benefits via their pension scheme.  These benefits are generally given to the surviving spouse or partner so are not treated as assets of the deceased’s estate.  But there is a massive potential Inheritance Tax (IHT) problem which can destroy 40% of their value.

Generally speaking most people nominate their death benefit to be paid directly to their spouse or partner which is fine - as far as most advice goes.  As a result, because the benefit is not treated as an asset of the estate, on the first death there is no liability to IHT.  However, IHT liability arises on the second death.  For example, on the death of the first spouse, the death-in-service pays a lump sum to the survivor.  This is outside the estate for tax purposes.  Once the benefits of the policy have been paid to the survivor they become an asset of the partners estate.  Subsequently, when the survivor dies their estate (which would include any death-in-service benefit monies) is subject to IHT at 40% on the value of the estate in excess of the IHT threshold.

This tax problem can be avoided by sending the death-in-service benefit or pension death benefit into a special trust.  The trust is held outside the survivor’s estate; (and therefore not subject to IHT on the survivor's death).  However the survivor can benefit from the trust and receive cash or other benefits.  Even more beneficially the trust can be drafted with power to loan monies to the survivor.  As a result the survivor will have the full use of the funds to invest or spend, or live off the income as they see fit.  However, as a loan has been made from the trust a liability has been created which can be paid out of the survivor's estate on their death thereby further reducing the value of the estate for IHT purposes.

Spousal by-pass trusts are not limited to death in service benefits and pension benefits.  They can be used in conjunction with any form of life insurance.  Therefore anyone with any type of term life insurance or mortgage protection insurance should consider placing the benefit of the policies into such a trust.  The surviving spouse can still be a trustee and therefore control how the funds are used.  This way considerable IHT savings can be made, though care must be taken to ensure that critical illness, cash value or other lifetime benefits don't accidentally go into the Pilot / Spousal By Pass Trust.

Many pension and life insurance companies offer precedent trust documents.  Whilst some of these contain the necessary powers to make loans, not all standard form trusts have the necessary powers and are limited in their usefulness.  If you decide to use these standard forms, do make sure that are completed correctly as putting the wrong name in the wrong box can cost you literally tens of thousands of pounds in IHT.

Alternatively we can draw up a "made to measure" trust for you incorporating the appropriate powers tailored to your own personal circumstances.

Whilst a discretionary trust, or any type of trust, has its own taxation regime upon which advice is required, in many cases it is certainly worth looking into this type of arrangement.

How else would I use a spousal by-pass trust?

Although these trust are mainly used to receive death in service benefits they can be created now to receive assets passed into them by Will such as business or agricultural property and if you have a substantial estate you may wish to consider multiple spousal by-pass trusts simply to increase the availability of the nil rate bands across the trusts.

What formalities are required?

These trusts can be set up quickly and are typically, but not necessarily, done at the same time as a testator drafts his Will.  They are normally discretionary and are created with a trust fund of as little as £10.

 What is the effect?

No spousal bypass

With spousal bypass

(NB The bypass trust will be subject to its own IHT regime: a charge every 10 years of 6% and an exit charge but it will be substantially less than the difference between £350,400 and £110,400 even if it is kept intact).

…………………………… a by-pass worth having!