This rather clumsy name represents one of the most popular ways that homeowners with valuable properties try to minimise their eventual inheritance tax (IHT) bills.

Nil-rate band trusts are in the news because HM Revenue & Customs has just lost a case heard by the Special Commissioners, who rule on arcane tax points. This favourable ruling for homeowners comes as the Revenue appears to be cracking down on IHT wheezes.

Meanwhile some tax accountants have suggested these trusts are safer than ever from Revenue scrutiny. 

What is a nil-rate band discretionary trust?

A discretionary trust is a commonly-used type of trust that is set up so that all income and benefits from the assets held in the trust are distributed at the discretion (hence the name) of the trustees. These trusts can be used for all sorts of reasons – such as in family tax planning, where wealthy families want to keep an eye on their trust funds to prevent cash being squandered.

When it comes to IHT planning, many professional advisers tell clients to opt for a specialised version of this arrangement, called a nil-rate band discretionary trust. The discretionary trust framework is used but the real aim is to provide a “wrapper” to shield assets to the value of an individual’s IHT exemption (also referred to as the nil rate band) which is currently £275,000. The exemption is like a voucher to be used after your death so that no inheritance tax is paid on the first £275,000 in the estate. Heirs pay 40 per cent tax on every penny above this figure.

If everyone gets this ‘free’ £275,000 voucher, why do they need to keep it hidden in a special trust?

Because, left unadvised, married couples only get one crack at the £275,000 exemption between them. It works like this: the first spouse, usually the husband, dies. Wills are usually drafted so all assets pass automatically between married couples after the death of the first partner – so the wife gets the enormously expensive house, investments, and so on. Inheritance tax is not charged between married couples and from December, these same rules will apply to same-sex partners in civil partnerships.

But when the second spouse dies, the whole estate is liable for IHT, minus the second spouse’s £275,000 nil rate band (it is called nil rate because it is taxed at 0 per cent). 

The clever trick of the nil-rate band trust is that it allows a couple to make use of both their individual £275,000 exemptions: once when the first partner dies, and again when the survivor does.

So how does that work?

First, the home ownership has to be adjusted so it is held by the couple as “tenants in common”. Then the couple make new wills to create the discretionary trust (which kicks in when the first spouse dies). When the trust is triggered by death, there’s an immediate bequest of the value of the nil-rate band for IHT – currently £275,000 – from the survivor’s assets, to be held in the discretionary trust.

This can be a part-share of the deceased’s interest in the family home, for example, given to the trust, or an IOU note given to the trust to the value of £275,000 to be paid out of the survivor’s estate after her death. Either way, the survivor can go on living in their lovely home. 

So how much actual IHT does this save?

Because the couple is getting two bites at the IHT-saving cherry, their heirs will save the tax they would otherwise pay on the £275,000 that’s been removed from the estate. So that’s a saving of £110,000 (40 per cent of £275,000). If set up properly therefore, a £550,000 property can effectively be sheltered from inheritance tax.

What’s the snag?

The difficulty is that, since 1979, the Revenue has tried to argue (not always successfully) that, where a share of the house is in a discretionary trust it is not always held on a discretionary basis at all, but is held for the exclusive benefit of the surviving spouse. That means the share of the house in trust should still be subject to inheritance tax on the survivor’s death and the IHT exemption of the first partner is therefore not preserved.

That’s why many accountants advise people to go down the IOU route when setting up their trusts, and the recent ruling has confirmed most advisers’ opinion that the IOU path is the one to take.

So what has this ruling said about nil-rate discretionary trusts and houses?

In a case of bewildering complexity (in the test case there was a £600,000 house sheltered in a discretionary trust) the presiding Special Commissioner decided against the Revenue, which was attempting to pursue the heirs in that family for IHT. The Revenue lost, but it has decided to appeal.

So, in theory at least, if the Revenue loses its appeal, where the wording of a discretionary trust is heavily influenced by the recent Special Commissioner’s ruling, this could make these trusts safer. Even so, some accountants still believe that trusts set up using the IOU structure are the safest.

Compiled with the help of Emma Chamberlain, barrister and member of the Chartered Institute of Taxation (CIOT), and Mike Warburton, partner, Grant Thornton.