Ten Top Inheritance Tax Planning Tips
1. Play ‘Leapfrog’
The reason inheritance tax (IHT) is such an insidious tax is because it attacks family wealth, like a sort of cancer, every generation. But often, you simply don’t need to submit to this regular erosion process. Let’s take an example.
The generation who are currently in their 50s and 60s, very often have been very successful financially and have not relied on inheritances or handouts from their parents. Their children, on the hand, are struggling to find the money to get onto the property ladder, or even to get a job. Let’s think of it in terms of generations 1, 2 and 3. Generation 1, who are at the age at which IHT planning is definitely appropriate, will normally have a will leaving everything they have (on second death of the married couple) to their children, that is generation 2. However, generation 2 may have no need at all of the legacies; in fact, they may be beginning to worry about their own IHT exposure, and the last thing they need, from this point of view, is further wealth inherited from their parents.
So the family wealth can leapfrog generation 2 and be left to generation 3. The taxman is deprived of his prey for another 33 years (on average).
This principle can be extended still further, by providing that generation 1 leave their wealth to family trusts rather than to individuals. Often, the size of generation 1’s estate will not actually be sufficient for that estate to bear IHT, or very much. Putting the estate into trust means not just that it doesn’t swell the taxable estate of generations 2, 3 (or 4 etc.) but even enables generation 2 to look on the trust funds as a nest egg in case of financial disaster. The trust is its own thing for IHT purposes, and will only pay a relatively modest amount of IHT, or nil, if it continues to exist as a family moneybox long term.
So IHT planning isn’t just for those who have a potential IHT liability. It’s also important to look at the wills of those whose children are potentially exposed to the tax.
2. Beneficiary not exempt? Not a problem!
It’s true that making gifts to the younger generations is a staple of IHT planning. But you do have to survive the gifts by seven years; otherwise, they come back into your estate and are chargeable to tax. Bequests to charities and spouses/civil partners are exempt, but this doesn’t tend to have the desired effect of allowing wealth to move down the generations in a family without being nabbed by HMRC.
But there is one great big exemption out there that applies even to gifts to the younger generations and is staring us in the face.
This applies where you make regular gifts to a given beneficiary or group of beneficiaries, and those gifts are out of ‘surplus’ income that isn’t needed for your own living expenses. You do have to make sure that the gifts are regular, so as to qualify as ‘normal’, and you do need to make sure that they are ‘out of income’ (whatever that means). However, if you manage to tick both of these boxes, there is no upper limit to the size of the gifts you can make – all of them completely exempt from IHT, even if you die within seven years.
This exemption can make the much trumpeted £3,000 IHT ‘annual exemption’ seem pretty pathetic, in some people’s circumstances.
3. Nil band planning is dead: Long live nil band planning!
When Alistair Darling introduced the transferable nil band in 2006, a lot of people thought that that was the end of the road for the previously popular nil rate band discretionary trust. We didn’t agree at the time, and we still don’t agree.
A nil band trust is a clause in the will saying that, on first death of a married couple, the maximum amount that could be given away to non-exempt beneficiaries (i.e. everyone except the surviving spouse) would go into a trust for the general benefit of that spouse and the rest of the family. Before 2006, you needed to do this to avoid losing the benefit of the first person’s available nil band (which is currently £325,000). Following the introduction of the transferable nil band, the urgency to have this sort of clause has gone, because any available nil band not used on first death can be passed down and used on second death of the couple.
However, if you are talking about an asset that increases in value more quickly than the nil rate band is increased by the government (and they don’t seem to be increasing it at all at the moment), it can still be a very good idea to, as it were, siphon off £325,000 worth of appreciating investments at the time of first death. That way the overall tax is reduced, because even though the second person to die only has one nil band available now, the estate on which they are taxable is reduced by more than the nil band that would have been transferred to them.
And remember that a nil band trust can be very flexible, to the extent of enabling the surviving spouse to benefit from the whole of the value going into it, if circumstances make this necessary. In short, apart from a little amount of extra administrative complexity, there’s no downside to having this arrangement.
4. Have your cake, eat it and pay no tax
When IHT was introduced in 1986, the newly introduced ability to make lifetime gifts to save tax came with an obvious danger, from the government’s point of view, that people would give away assets, to save IHT, but still retain the effective use and enjoyment of them. Having their cake and eating it, in other words. So they resurrected from the old estate duty rules the concept of gifts with reservation of benefit. If you give something away, and reserve a benefit in it, it’s treated for IHT purposes as if you still owned it, and therefore is fully charged to tax on your death.
The classic example of this, of course, is the elderly couple who give away their house to their children but continue to live in it. The couple that do this have achieved precisely nil in IHT-planning terms, and have actually made the capital gains situation worse. Unless the children are living in the property themselves as their ‘main residence’, the house will cease to qualify for ‘main residence’ exemption in their hands.
This brings us on to the important exception to the gift with reservation rules, that applies where you give a portion of your house away. This is the situation where the recipient lives with you in the house. This is not at all uncommon, particularly in these days of ballooning house prices, and may also apply if the recipient individual is disabled or otherwise dependent on you. The share of the house that you give them, as well as representing an effective gift for IHT purposes (providing you survive seven years) will also continue to enjoy capital gains tax (CGT) exemption.
5. Watch out for the new ‘elephant traps’
The main purpose of the annual Budget, at least ostensibly, is to put before Parliament the way that the government plans to balance the books. Increasingly, though, it’s seen by HMRC as an excuse to introduce a lot more horrible new rules. With the emphasis on the words ‘a lot’ as well as on the word ‘horrible’. One example of this is the new rule preventing liabilities from being deducted from a person’s estate on death, where those liabilities are not going to be paid off in money, in practice. So, for example, the older generation may have entered into arrangements under which they have given IOUs to the younger generations, or trusts, which are simply going to be wiped out as part of the resolution of their estates after they have shuffled off this mortal coil. These arrangements may no longer work, so check very carefully to see whether liabilities you have, or your aged parents have, can still be deducted in the new, more hostile IHT-planning regime.
6. Every man his own actuary
If you are looking to make substantial gifts to save IHT, take a moment to think about who it is that is actually making those gifts.
If both husband and wife are still alive, inevitably one is going to be more likely to survive the necessary seven years than the other. Actuarially, of course, in a married couple it is the wife who is likely to live longer, even if she is the same age as her husband, but one obviously needs to take into account things like state of health, and whether one of the spouses, but not the other, is a devotee of hang-gliding or Thai kickboxing.
Within reason, there doesn’t seem to be a problem with transfers of assets between the two spouses, so that it is the younger and/or healthier one that makes the gift to the next generation. You also have to take into account, of course, the availability of the nil band for each of the two spouses. A cold-blooded calculation of probabilities and estimated tax liabilities if things don’t go the right way is very important when considering making substantial gifts.
7. Unapproved pensions, and other trusts
The same principle applies to trusts generally, but with unapproved pensions, which are a type of trust, the point perhaps needs making particularly strongly. If you are a beneficiary of a FURBS, EFRBS or one of the other sorts of unapproved pension arrangements made for your benefit by your employer (often, in practice, your own company), consider carefully whether you want to take the benefits out of the pension fund or not. If you don’t need the capital sum, bringing it out of the trust and paying it to yourself, even though it may give you a frisson of tax-planning pleasure by being an income tax free lump sum, has the sting in the tail of bringing the value into your estate for IHT purposes.
By contrast, most unapproved pensions, being discretionary trusts, are outside the estate of any individual for IHT purposes. Left in trust, the amounts can in most cases be paid out to the younger generation (do check the rules) after the original beneficiary’s death, tax-free.
8. Be a ‘sleeping partner’
If you don’t want to give your assets away, but want to keep some kind of financial security, or control over those assets, you can still plan to reduce your IHT. One way to do this is to invest in relievable assets, in particular assets that qualify for business property relief.
This doesn’t necessarily mean setting up a widget manufacturing business in your 80s. Business property relief can be achieved by a number of types of investment that are partly or wholly passive ones from the point of view of the investor. For example, a lot of companies and venture capital trusts quoted on the Alternative Investment Market (AIM) qualify for the relief while being effectively indistinguishable from quoted shares. Of course, you have to bear in mind that this can result in the very best IHT planning of all – by losing all of the money you have invested!
Nearer to home, an investment in shares in your son’s, or grandson’s, company is likely to qualify you for relief, and you can take a dividend by way of return if you need the income.
9. Old MacDonald had a farm – and paid no IHT
Agricultural property goes one further than business property, as IHT-favoured investments go. An investment in agricultural land and working farm buildings qualifies you for 100% relief without any trading risk – by letting the property to the working farmer. You need seven years of ownership to qualify for the 100% relief, if you are letting the land etc. rather than farming it yourself; however, agricultural property comes with all kinds of advantages as an investment, including the possibility, in some cases, of gains from development in the future.
If anyone out there knows of any syndicated arrangements under which agricultural property can be held for IHT-planning purposes, do let us know.
10. The multifaceted use of trusts
The government struck a body blow at trusts, as tax-planning vehicles, when, in 2006, it made gifts into almost all types of trusts chargeable to IHT at 20%, with the tax being chargeable at the time of the gift.
But a body blow is one thing, and a death blow is another. Trusts are still tremendously powerful tools of IHT planning.
Perhaps the main reason for setting up a trust, rather than making an absolute gift, isn’t tax related at all. A trust, unlike an absolute gift, means that the wealth can be held for the benefit of individuals without being in their grasp. This can be a good way of protecting family wealth if the beneficiaries (usually the younger generation) are likely to run into any kind of financial difficulty, whether because of matrimonial break-up or otherwise. So a trust can be a way of taking value out of your own IHT chargeable estate without putting the money at the tender mercies of the younger generation.
A more directly tax-related benefit of trusts, though, is that you can ‘hold over’ any capital gain on an asset going into the trust. Let’s suppose that a husband and wife have an investment property worth £600,000 that cost them £100,000 many years ago. Making an absolute gift of this property to their children, which is what they really want to do, is good IHT planning but absolutely lousy CGT planning, because the £500,000 ‘gain’ that is calculated by reference to the market value of the property becomes chargeable on the gift.
If, instead, they give the property to a trust for their children, the gain can be held over.
The £600,000 figure, of course, was carefully chosen to illustrate the IHT principle that applies to such gifts into trust. If the donors haven’t made any other transfers into trust within the last seven years, and if they survive another seven years, a gift of this size will not be chargeable to the 20% IHT lifetime tax that we mentioned just now. This is because they have their £325,000 nil band available. So, between a couple, amounts that are relatively substantial, to a lot of families, can still be put into trust without incurring this horrible new (2006) tax charge.
If what is being put into trust is relievable, for example if it qualifies for business property relief, or agricultural property relief, the amounts of value that can be put into trust are, of course, much greater. If the rate of relief is 100% (which it is in most cases), in fact, there is effectively no upper limit at all as to the value that can be put on trust. The 20% charge only applies to the IHT chargeable value, which is nil, however much business or agricultural property you put on trust. Always bear in mind, though, the alternative of retaining the business or agricultural property concerned in your estate. Unless they change the rules, this won’t bear IHT on your death in any event, and leaving it to the next generation in your will, rather than putting it in trust, achieves a tax-free uplift in the value of the asset for CGT purposes.
So, in practice, the use of trusts for IHT planning is likely to be more relevant for assets that don’t qualify for business or agricultural property reliefs, like investment properties or shares in investment companies.