Preserving the Inheritance

The current regime

The key points of the current regime are as follows: 

•  IHT is charged on a person’s estate when they die and on certain gifts made during their lifetime
• the rate of tax on death is 40% and 20% on lifetime chargeable transfers. The first £312,000 is not chargeable 
• some lifetime gifts are treated as ‘potentially exempt transfers’ or PETs. So long as the donor lives for at least seven years after making the PET there will be no possibility of an IHT charge whatever the size of the gift 
• there are numerous exemptions and reliefs.

So what's the problem?

IHT is still a problem because:

• many are simply not in a position to make substantial lifetime gifts because it will leave them with insufficient capital to live on. As a consequence there is likely to be significant value retained in estates on death 
• at the time of writing the threshold for IHT, £312,000, is roughly the same as the average price of a detached house in England and Wales. In such a case the house alone will use up the nil rate band and any remaining assets, such as investments and cash reserves, will be charged to IHT at 40%.

It is important therefore to consider ways of reducing any potential IHT liability.

Mitigating the liability

Don’t waste your exemptions

Regularly using IHT exemptions will build up funds outside of the estate without incurring an IHT liability. A husband and wife can each take advantage of the exemptions, the main ones being:

• an annual allowance of £3,000 per donor per year. It can be carried forward for one year only if unused
• small gifts not exceeding £250 in total per donee per tax year
• gifts made out of income that are typical and habitual
• gifts made in consideration of marriage up to £5,000 if made by a parent, £2,500 by grandparents and £1,000 by others
• gifts to charities whether made during lifetime or on death
• gifts between spouses and registered civil partners, whether made during lifetime or on death.

Tax Planning Remember that marriage invalidates any existing Will so make sure you write a new Will. This can be done before the wedding but in anticipation of it.

Planning in lifetime

If possible you should make absolute gifts in lifetime. A gift to an individual will be a PET so there will be no liability if the donor survives seven years. Even if the donor fails to survive for all of that period there will be a tax saving because the charge which will arise on the PET will be based on the value of the asset when it was originally gifted and not on the value at the date of death. If the value of the gift is below the threshold there will be no charge. If any tax is due it will be reduced to reflect the actual period between the dates of the gift and death.

Tax Planning Each spouse/civil partner can take advantage of the IHT nil rate band. Furthermore gifts between them are exempt. Therefore it pays to use this exemption to broadly equalise estates so that both partners can make full use of exemptions and the nil rate band.

Remember that you cannot continue to benefit in any way from the asset gifted because this will render the gift ineffective for IHT purposes. You cannot, for example, give away your home to your children but continue to live in it rent free.

Consider using trusts

Trusts can provide a way of reducing IHT liabilities not just for the donor but also for the donee. The rules are complex but significant tax savings can be achieved with careful planning. In particular, trusts can be an effective way of using important reliefs on businesses and agricultural properties.

Use the nil rate band on death

On death, assuming the nil rate band has not already been utilised in the last seven years, it pays to ensure that it is not wasted. The government has helped in this area in recent times. New rules allow any unused nil rate band on the death of the first spouse to be transferred to the estate of the surviving spouse. The new rules apply to surviving spouses who die on or after 9 October 2007.

Example

Tom died leaving the whole of his estate of £800,000 to his wife Pru. A few years later Pru died leaving her whole estate of £900,000 to her children.

Under the old rules, on Tom’s death there was no IHT, as transfers between husband and wife were exempt, but on Pru’s death the IHT payable is based on £588,000 (£900,000 less the current nil rate band of £312,000).

Under the new rules, the portion of any nil rate band unused on the death of Tom will be allowable against Pru’s estate. In this case as Tom’s estate was left to Pru, none of his nil band was utilized, so 100% is available. This is in addition to Pru’s own nil rate band. Using the current rates the IHT payable on Pru’s death is based on £276,000 (£900,000 - [£312,000 x 2]).

Whilst the changes will help many married couples, better planning could completely eliminate the IHT bill.

Discretionary Will trust

Couples with modest estates find it hard to leave the nil rate band to children in their Will since that may leave the surviving partner short of funds. This can be overcome by the use of Discretionary Will trusts.

Put very simply, the Will leaves an amount equal to the nil rate band into a discretionary trust and the remainder can pass to the surviving spouse. There will be no IHT. The trustees will be given powers to pay income or capital to the surviving partner from the trust in the event that funds are needed.

Tax Planning Using trusts can provide an effective means of removing assets from an estate but still allow flexibility in their ultimate destination and allow the donor to retain some control. Some trusts are quite tax efficient but recent changes have somewhat limited this effectiveness. Contact us for more advice on this area.

On the death of the surviving partner this discretionary trust is outside of their estate and any assets owned in the surviving parties own right will attract the nil rate band.

The family home

As already mentioned, the growth in house prices has caused real IHT worries. The family home is often the largest asset in an estate and is the hardest one to deal with efficiently for IHT purposes because individuals need a place to live. There have been many schemes devised to solve the problem and HMRC have successfully tackled many of these.

It is still possible to plan to mitigate some of the effect of the value of the family home particularly by careful planning using Wills. An important prerequisite of such arrangements is that the property, if occupied by spouses, should be owned by them as tenants in common and not simply as joint tenants. This means that each spouse has a clearly defined legal interest in the property which can be left according to their Will and does not automatically fall into the ownership of the survivor.

Use the reliefs

Important reliefs of up to 100% are available on business assets such as shares in a family trading company or on agricultural property. It is important that these reliefs are utilised because once the asset concerned is sold the relief will be lost. They can only be used in connection with transfers which are chargeable to IHT. In lifetime it may be worth considering transfers of such assets into trusts for members of the family. On death such assets should not automatically be left to the surviving spouse because that transfer will be exempt and, if the survivor subsequently sells the asset, the relief will have been wasted.

Make a Will

If you die without a Will, the intestacy provisions will apply and may result in your estate being distributed in a way you would not have chosen. Keep your Will up-to-date to reflect changes in the family situation. In particular Wills need to be revised on marriage or on divorce.

Use life assurance

Life assurance arrangements can be used as a means of removing value from an estate and also as a method of funding IHT liabilities. A policy can be arranged to cover IHT due on death. It is particularly useful in providing funds to meet an IHT liability where the assets are not easily realised, eg family company shares.

Tax Planning Do you have a Will? Where is it kept - do you and your family know? Is it up to date? Does your Will make full use of IHT exemptions and reliefs? Do you have adequate life assurance?

For information of users: This material is published for the information of clients. It provides only an overview of the regulations in force at the date of publication, and no action should be taken without consulting the detailed legislation or seeking professional advice. Therefore no responsibility for loss occasioned by any person acting or refraining from action as a result of the material can be accepted by the authors or the firm.

Prime Chartered Accountants
Fact sheet published June 2008