When you take out a life assurance or pension policy the provider will ask you who will benefit from the policy on your death. Married couples and registered civil partners will usually nominate their spouse or civil partner as the beneficiary of any lump sum payable. Generally speaking this will not be liable to inheritance tax on the first death but it will become part of the surviving spouse's or civil partner’s estate and potentially taxable at 40% on their death.
There is a simple way to avoid the lump sum being liable to inheritance tax and that is to nominate that it passes into a trust commonly, and unattractively, called a Spousal By-pass Trust.
This trust is usually discretionary in nature and will have a class of potential beneficiaries that will include the surviving spouse or civil partner who can also be appointed as one of the trustees so that they can enjoy a degree of control over the use of the trust fund. The settlor, the person deciding who benefits, will usually leave a letter of wishes directing the trustees as to how the fund might be used.
The trust can also be drafted with power to loan monies and as a result the survivor will have the full use of the funds to invest, spend or simply draw down 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 reducing the value of their estate for inheritance tax purposes.