Money: Even if you don't have pounds 17m, you should still worry about inheritance tax

Last year more than 50,000 people died leaving assets in excess of pounds 5,000 and no will. At the very least their money may well not go where they would have wanted and at worst it might end up in the Chancellor's coffers.

The story goes that Princess Diana forgot to take into account the pounds 17m she received from Prince Charles in her divorce settlement last year. She could easily have avoided her sons having to pay 40 per cent tax on the money if she had bothered to update her will, it has been claimed. But the reports are not strictly correct.

According to Richard Bark-Jones, partner at Liverpool-based solicitors Moorcroft Urquhart and a member of the Law Society's Wills and Equity Committee, the Princess's settlement would have been subject to tax even if she had immediately transferred the whole of the proceeds into a trust (strictly speaking an interest in possession trust) for her children, because she did not live for the seven years needed to make a trust exempt from inheritance tax.

Under current rules the beneficiaries of a trust can enjoy the income or it can be allowed to accumulate, and the assets are entirely exempt from inheritance tax if the donor lives for seven years after making the transfer.

But if he or she dies in the first three years after making the gift or transferring it to a trust the tax has to be paid in full. The tax due is reduced by 20 per cent in the fourth year, 40 per cent in the fifth, then 60 per cent in the sixth and 80 per cent in the seventh, and only after seven years is the gift exempt.

The divorce settlement would only have been tax-efficient if Prince Charles had made two settlements last year, one in favour of the Princess and the other in favour of his children.

The possibility was presumably considered and rejected by the Princess's lawyers, either because the Princess was 12 years younger than her ex- husband and would normally have expected to outlive him, or perhaps because it was considered she needed the income from the whole settlement to maintain her lifestyle.

Once that opportunity was allowed to pass it might still have been possible for the Prince to appeal to the court to vary the terms of the settlement after the death of the Princess, on the grounds that her untimely death had frustrated the intention of the original settlement.

His lawyers could have cited the so-called Bader Principle, (named after a case in 1988 where a divorced wife later committed suicide) with an excellent chance of success, says Mr Bark-Jones, especially if her executors agreed.

But this option has been rejected on the grounds that the last thing the monarchy needs right now is an accusation that it is bending the rules to avoid paying the taxes which it only relatively recently agreed to pay.

As things stand the Princess's estate excluding any trusts set up more than seven years ago would only have the same exemption as any other single person. Anything in excess of pounds 215,000 would be subject to tax at 40p in the pound.

There is a lesson here for many other married couples. Married couples can leave assets to each other free of inheritance tax. No tax is due until the survivor dies. But once one dies their tax-free allowance dies with them, and once they have split up they can no longer transfer assets to each other free of tax, even if they wanted to. So wealthy married couples should consider sharing their assets while they live together and using their inheritance tax-free allowances to leave something to their children rather than their spouses when they die.

Even these rules could be out of date by the time you read this. Changes in both capital gains and inheritance taxes were hot favourites for inclusion in the Chancellor's Green Budget yesterday.