Inheritance Tax

This guide is designed to help you through the maze of Inheritance Tax. We outline who needs to be concerned and explain how it works. Also, we mention some of the allowances you can use to help mitigate its effects on your estate.

Inheritance tax has traditionally been seen as a tax only for the very wealthy. However, there is a threshold of £325,000, which is £650,000 for married couples and civil partners. This threshold will remain frozen until 2021. The price of houses are still relatively high. Therefore, more and more people could find themselves caught in the net. This could lead to many people having to sell long-held family heirlooms or investment assets to meet tax bills. With a little bit of planning, this could be avoided.

If you would like to discuss any of the points raised on Inheritance Tax, please do not hesitate to contact us.

What is Inheritance Tax?

Inheritance tax is payable when someone transfers ownership of their assets, usually on death. Each individual is entitled to a nil-rate band of £325,000, under which no inheritance tax is payable.

Traditionally, very few estates have exceeded this nil-rate band. However, the house price boom of recent years has pushed more people into the Inheritance Tax net. Alongside ISAs, death-in-service benefit, foreign homes or less obvious assets, such as paintings or cars, this has boosted the value of an average estate.

The tax rate for all assets over the nil-rate band is 40%. Therefore, it is possible to build up a large bill quickly. Also, inheritance tax becomes payable relatively quickly. It is due six months after the end of the month of death.

This does not give the administrators much time. For example, time to sell a house or liquidate other assets, if that is necessary. With that in mind, if you die unexpectedly and your estate now exceeds the taxman’s limits, what can you do?

Although the Government closed many of the loopholes on inheritance tax in the 2006 budget, a number of exemptions and allowances do remain. Where possible, you should aim to maximise use of these exemptions and allowances. Do so if you wish to pass on as much your hard-earned cash to your heirs as possible.

Exemptions and Allowances

In addition to the £325,000 nil-rate band available on each estate, transfers between husband and wife or between civil partners are free of tax.

Since 9th October 2007, such legally recognised partners, can also pass over any unused portion of their own nil-rate band. Therefore, in effect, the surviving spouse has up to £650,000. However, this does not apply to cohabiting partners or ‘common- law’ spouses.

Moreover, from 2017, an additional, transferable nil-rate band will be phased in. This will enable individuals to pass on their house to direct descendants. These could be children or grandchildren. They can do so without incurring Inheritance Tax.

When added to the existing nil-rate band of £325,000, this creates an Inheritance Tax threshold of £500,000 for estates by 2020-21. Any of this unused allowance can be transferred to the surviving spouse or civil partner. This raises the effective Inheritance Tax threshold to £1 million by 2020/21. Moreover, homeowners who opt to downsize will not lose their allowance. However, estates with a net value of over £2 million will suffer a tapered withdrawal of the main residence nil-rate band.

Potentially Exempt Transfers

The majority of other exemptions and allowances come about through distributing some of your wealth prior to death. Such assets transferred prior to death, are termed ‘Potentially Exempt Transfers’ for Inheritance Tax purposes. They are potentially exempt because, from the day you give them away, the tax due on death is subject to a tapering over seven years. This starts at 100% of liability for three years, then falling proportionally from 80% over the next four. If you survive the full seven years, the Inheritance Tax liability on that asset becomes zero.

However, this taper relief only applies to amounts in excess of the nil-rate band. As there is no tax due on the first £325,000, no taper relief can apply. Therefore, if you give away anything up to £325,000 and die within those seven years, the full amount of the original gift, will be added back into your estate. In addition, tax will be calculated on the total, as if you never gave that amount away.

Furthermore, if you do survive seven years, the amount is considered as having left your estate. Therefore, you get the chance to benefit from the nil-rate band allowance a second time.

There is an important restriction on Potentially Exempt Transfers. This is called a ‘gift with reservation of benefit’. The principle is that if you continue to enjoy the benefit of an asset, the transfer is entirely ineffective for inheritance tax purposes. This is in place to stop parents, for example, transferring their homes to their children and continuing to live in them. In order for such a transfer to be potentially exempt, a full market rent would have to be paid to the children after transfer.

Inheritance Tax on Gifts

Gifts of £3,000 or less are allowed annually without being liable for Inheritance Tax. Furthermore, if unused, this allowance can be carried forward for one year.

There is also a gift exemption applying to ‘regular gifts out of income’. These gifts can be as much as you like. However, they must form part of a ‘pattern of giving’. In addition, the Inland Revenue must be satisfied that after the gift has been made, you are left with sufficient income to maintain your existing standard of living.

Also, you are allowed gifts on consideration of marriage or civil partnership. The amounts vary according to your relationship to the bride and groom. At the moment, £5,000 is allowed from the parents, £2,500 from the grandparents and £1,000 by anyone else. Gifts to charities also fall outside inheritance tax.

Taking Practical Steps

You can take some basic steps to ensure that you make full yet practical use of your allowances and exemptions. Planning ahead is very important. If in doubt, always take professional advice.

First Step – The Basics

Making a will is vital. If you die ‘intestate’ (without a will), your estate will be divided up according to the rules of intestacy.

It is particularly important if you are not married. This is because you would be unlikely to inherit a ‘common-law’ partner’s money, or even their share of your house.

For example, under the laws of England & Wales (the Inheritance and Trustees’ Powers Act 2014), your legal spouse or civil partner receives the personal chattels. Also, £250,000, plus half of the remainder of the estate. Then the balance is divided equally amongst your children . Perhaps you do not have any children, so your spouse/civil partner will inherit the entire outstanding estate.

If you have no spouse/civil partner, it will pass to your children or their descendants. On the other hand, of you have neither spouse/civil partner nor children, your parents will inherit, followed by your siblings, then grandparents, then your uncles/aunts, or finally your cousins.

If you have no legally recognised family, it goes straight to the Crown.

Please note, in Northern Ireland , the intestacy rules are similar to these, however, in Scotland, the rules are quite different.

Here, the intestacy laws are governed by the Succession (Scotland) Act 1964. Therefore, makes the situation a little more complicated. Always check with a professional adviser to understand how the laws apply in your location.

Second Step – Using Trusts

Trusts have long been viewed as an easy way to brush off an inheritance tax liability. If this were ever the case, it certainly was not after the 2006 Budget. This closed down many of the tax planning opportunities for investors. Furthermore, under the new regime, ‘Interest in Possession Trusts’ and ‘Accumulation & Maintenance Trusts’ became subject to the same Inheritance Tax treatment as discretionary trusts.

Now, transfers into most ‘Interest in Possession Trusts’ and ‘Accumulation & Maintenance Trusts’ over the donor’s nil-rate band. are subject to an up-front 20% Inheritance Tax charge. These trusts are also liable to a periodic charge every ten years. Also, an ‘exit’ charge when funds are taken out of the trust.

If a donor puts money into one of these trusts, they pay the 20% tax on any amount above the nil-rate band. If they die within seven years, they are liable for the balance of Inheritance Tax due. However, if they survive seven years, the donor will have the chance to use their nil-rate band again.

Third Step – Consider Life Assurance

Life assurance can be a useful way to accumulate enough money to pay your inheritance tax bill. Furthermore, when placed in trust (and funded from regular income as part of a ‘pattern of giving’), is also free from inheritance tax. This means that you do not create an additional Inheritance Tax burden. This is because the trust keeps that lump sum payment out of your estate.

This can be particularly useful from a liquidity point of view. Reason is the lump sum will be readily available to your beneficiaries to pay the taxes, while the estate itself is being unwound.

Other Inheritance Tax-planning Tools

Discounted Gift Plans

Discounted gift plans are basically investment bonds. They are wrapped in a trust. Also, designed to minimise, although not eliminate, Inheritance Tax liabilities. You can put a lump sum into a plan and then take out up to 5% of the capital tax-free each year.

At the point at which you put money into the plan, a designated discount rate decides how long you are likely to live. In addition, how many years the 5% is likely to be paid out. So therefore, how much of the trust is ‘yours’ and forms part of your estate.

The remaining assets, including any growth, are free from tax. This is providing you survive seven years. However, these schemes do depend on having disposable cash, a need for income, and a reasonable expectation of surviving the full seven years.

Investments Providing Tax Relief

The value of most investments will be subject to inheritance tax, including ISAs, property, art, wine and foreign property. However, a number of investments can qualify for Inheritance Tax reduction or relief. For example, if you have held shares in an Enterprise Investment Scheme for more than two years, it will fall out of your estate for inheritance tax purposes.

However, an Enterprise Investment Scheme involves investing your money into unquoted companies. Therefore, you run a higher risk than other investments of losing some or all of the value. Consequently, you need to be certain that you are comfortable with this additional risk before considering the Inheritance Tax benefits. Ultimately, paying out 40% of something is better than saving 40% of nothing.

Notwithstanding this, if you are a business owner, the benefits may help you to pass on your own company. This is providing it meets the criteria. There are also two types of tax relief available for investments into business or farming. They are business property relief and agricultural property relief.

Summary

Inheritance tax is perhaps no longer quite the ‘voluntary’ tax it was once considered. However, careful planning to ensure you take advantage of all the allowances and reliefs available, could save you a lot of money relatively easily. It is never too early to start.