The amount your estate might have to pay in inheritance tax could come as something of a surprise, so planning ahead is vital.
12 August 2019
Not getting around to inheritance tax (IHT) planning is understandable. Few of us enjoy thinking about our own mortality – and it can seem like a lot of effort.
But when you consider that IHT can potentially gobble up 40% of the assets you’re hoping to leave to your loved-ones, it’s well worth having a plan in place to reduce your liability.
The huge increase in house prices over the past couple of decades has meant that the value of many people’s estates far exceeds the IHT reliefs available, especially in London and the South East. And the reliefs often come with conditions attached, meaning they won’t apply in every case and people may be left with larger tax bills than expected.
For some, the much-publicised future scrapping of IHT on £1m homes won’t have quite the impact they hoped for. The exemption comes into full effect in the tax year 2020/21 and will only apply to parents or grandparents when they pass on a ’main residence’ to their children, step-children or grandchildren.
However, the additional exemption for main residences – the Residence Nil Rate Band (RNRB) – is reduced if an estate is worth more than £2m, by £1 for every £2 in excess of that amount, eventually reducing the additional relief to nil.
However, with careful planning, the effective IHT rate can be substantially reduced – particularly for larger estates. That’s because larger estates tend to comprise other assets besides property that qualify for reliefs. One example is business property relief, which exempts qualifying trading company owners from IHT if they want to leave the business to their children.
Working out how much IHT you’ll pay
IHT is normally payable on death at 40% on the value of your estate in excess of the available nil-rate band. However, there are numerous exemptions and reliefs to consider when calculating the value of your estate.
Transfers to your spouse or civil partner are usually exempt, so if the whole estate is left to a surviving spouse there is no tax to pay.
The nil-rate band on the death of the second spouse is increased to reflect the proportion of nil-rate band unused by the first spouse. This means that double the usual £325,000 nil-rate band may be available – £650,000. Any unused RNRB can similarly be transferred to the surviving spouse.
Jointly held assets
Where property is owned as joint tenants, the property passes to the surviving joint tenant, but it’s still included in the deceased’s estate on death for IHT purposes. Holding property in his way doesn’t save IHT – it simply determines who gets your share without the need to refer to your will.
The usual ways in which you can reduce your IHT liability are by giving away assets to reduce what’s in your estate or holding assets that are treated favourably for IHT. Leaving at least 10% of your net estate to charity can also reduce IHT to 36% (see Simon Robinson’s Viewpoint column for more on this).
Most employees will have life cover provided by their employer, typically three times their annual salary. By default, on death the proceeds of the policy are paid into your estate and are therefore potentially subject to IHT. It’s normally quite straightforward to have some or all of this paid directly to someone else, so that it never forms part of your estate.
This is likely to be especially appealing if you want to leave significant assets to someone who is not your surviving spouse. For example, the exemption for transfers between spouses or civil partners doesn’t apply to unmarried couples.
It can make sense to take out diminishing term life assurance on the life of the donor. This can be matched to the potential IHT exposure (which reduces because of taper relief).
One of the most common ways to reduce the value of an estate is to give things away while you’re still alive.
These are usually what is known as potentially exempt transfers (PETs). They only become exempt if the donor survives for a further seven years, although taper relief applies to any tax on the gift after three years. This means that no tax will necessarily be saved if a potentially exempt transfer is made within three years of death – as the gift will still be included in the IHT calculation.
But any increase in value of the asset given away after the gift was made will be outside the estate. It’s the value of the gift when made which is still included in the estate.
Some lifetime transfers (notably to discretionary trusts) are chargeable transfers, and IHT will initially be payable at 20% to the extent they exceed the available nil-rate band. This increases to 40% if the donor dies within seven years.
Potentially exempt transfers (PETs) within seven years of death
Where a PET is made and the donor dies within seven years, depending on the previous transfers, IHT may be payable by the recipient, or the IHT payable by the estate is increased because the PET uses up some, or all, of the nil-rate band.
Reservation of benefit
Many people are reluctant to completely give up access to, or control over, their assets. For example, giving away the family home or holiday home but continuing to use it rentfree. This may seem an easy way to sidestep IHT, but in these circumstances, known as reservation of benefit, the asset remains in the donor’s estate, so there is no IHT saving.
Some gifts are specifically exempt with no upper limit, including gifts to ’qualifying charities’, political parties and national institutions (such as museums, universities and the National Trust).
Other gifts are exempt within limits – annual gifts out of capital (£3,000), small gifts (£250 per recipient), parental gifts on marriage (£5,000), grandparents’ gifts on marriage (£2,500), and other gifts on marriage (£1,000).
Gifts out of surplus income
This noteworthy but often overlooked exemption enables a donor to maintain their normal standard of living without dipping into their capital. Such gifts can stop the exposure to IHT getting worse.
For example, the IHT saving in relation to a widower with after tax income of £50,000 (perhaps enjoying an old final salary scheme) and annual expenditure of £20,000, who gives away £30,000 per annum, could save IHT of £60,000 after five years (£30,000 x 5 x 40%). There must be a recurring element to the gifts, but the effect of this is often that the total given away can be significant, and there is no upper limit to the exemption, or requirement to live seven years.
Business Property Relief
The value of assets that qualify for Business Property Relief (BPR) is discounted for IHT purposes by either 100% or 50%, but only usually once they have been held for two years.
Relief at 100% applies to interests in unincorporated businesses and unquoted shares in most trading companies (AIM-listed shares are treated as unquoted). This relief often applies to shareholdings in family companies, including minority interests.
It’s worth noting that BPR can apply to lifetime transfers, not just on death. This means that BPR assets (100% rate) which are given away will keep their IHT relief status, so it doesn’t matter whether the donor survives for seven years or has made other gifts. Do note, however, that the shares must still be held and still qualify for BPR should the donor not survive seven years.
BPR can also be used as a way to put larger sums into a trust for your family, as BPR qualifying assets do not suffer the penal 20% IHT charge on larger gifts to trusts.
There are other assets classes which also qualify for IHT relief, but that is beyond the scope of this article. Talk to your Shipleys contact for more information.
Spending ’without stint’
This might seem an extravagant way to reduce the value of your estate, but is a serious suggestion. If 40% of what you don’t spend ends up in the hands of the taxman this should seriously reduce, or eliminate, any feelings of guilt over expenditure perceived as excessive, if the cost is effectively subject to a 40% discount.
People domiciled outside the UK are only normally subject to IHT on their UK assets (rather than their worldwide estates for those domiciled in the UK). The inter-spouse exemption is restricted to a cumulative £325,000 on assets a UK domiciliary transfers in lifetime or on death to their non-domiciled spouse. However, the non-domiciled can elect to be treated as UK domiciled so that the interspousal exemption applies without limitation, but then their worldwide estate, as opposed to just UK assets, would be subject to IHT.
The Office of Tax Simplification has suggested some major changes to the IHT system, which may come into force in the not too distant future. Clients should therefore take care and seek advice before doing anything in relation to IHT.
Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary, if you would like advice or further information, please speak to your usual Shipleys contact.
Copyright © Shipleys LLP 2019