Guide to inheritance tax planning
An increasing number of people are becoming liable to inheritance tax because of the increase in property prices from the early 1980s to 2007.
Inheritance tax applies to your entire worldwide estate (including property) and is charged at 40 per cent, so anyone with a property in London or the south east may well fall into the IHT net by virtue of the value of their property alone.
But you also need to add in the value of savings, investments and chattels (antiques, jewellery, paintings etc) to estimate the entire value of your estate.
However, everyone has an IHT nil rate allowance (known as the 'nil rate band') up to which you pay no IHT. This band increases each year as follows:
£312,000 (2008-09) or £624,000 for a married couple, or registered civil partners
£325,000 (2009-10) or £650,000
£350,000 (2010-11) or £700,000
Although these are modest annual rises, the Chancellor of the Exchequer, Alistair Darling, has said that house price inflation will be taken into account in future.
How can I avoid IHT?
There are various exemptions which enable you to reduce your potential IHT bill, but these should be used with care. Once you have gifted money or property away, you cannot usually make use of it and still claim exemption from IHT.
Make a will
Your starting point always should be to write a will and review it every few years to check that it still reflects your wishes and dovetails with prevailing tax legislation. Failure to review your will, or to write one at all, can result in your estate passing to the wrong people.
Why is a will essential?
A will allows you to:
direct who receives your assets - in the absence of a valid will, the intestacy rules dictate what your spouse/ civil partner and wider family receive;
pass your estate to someone other than a spouse or civil partner who might otherwise inherit everything under the current intestacy rules.
state whom you wish to be the guardians of ooyour children;
make IHT-free legacies to charities and national institutions;
bequeath individual possessions to close friends or family members.
Divorce, or dissolution of a civil partnership, could cause parts of your will to be nullified and marriage or remarriage may completely invalidate a current will. Also if you change an existing will, it is generally a good idea to start the new one with a clause stating that it 'revokes all previous wills.'
What are exempt transfers?
Exempt transfers (see list below) allow you to gift various amounts to various beneficiares each year with no IHT liability, although all such gifts should be recorded.
'Gifts out of surplus income' should be treated with particular care and recorded, as they must be:
regular payments from your income, and
not have a detrimental effect on your normal standard of living.
Which other transfers are exempt from IHT?
All transfers between UK domiciled spouses/civil
partners (but only £55,000 if your spouse is non-UK domiciled);
gifts to charities and political parties;
gifts to national institutions (e.g. National Trust, British Museum);
gifts for maintenance of the family;
regular gifts out of surplus income (which do not affect your standard of living);
small gifts of up £250 pa to any number of individuals;
£3,000 pa to any individual/s (e.g. £1,000 to each of three children, or £3,000 to one child).
This exemption can be rolled over for one tax year, but cannot be combined with small gifts:
£5,000 gifts from each parent to a child on marriage/ civil partnership
£2,500 gift from each grandparent (or remoter ancestor), to a grandchild on marriage/civil partnership;
£1,000 gift from any other person on marriage/ civil partnership
Potentially Exempt Transfers (PETS)
For other gifts, which do not fall within the 'annual gift exemptions' listed above, unlimited direct gifts can be made during your lifetime to any individual, but these will be treated as 'potentially exempt transfers' or PETs and you must survive seven years from the date of making the gift for it to be free of IHT.
If you die within the seven years, the IHT payable is calculated on a sliding scale, known as taper relief (see below), ranging from 40% in the first three years, to 8pc in the seventh year, on any excess over the nil rate band.
Taper relief (IHT charged if you die within 7 years of making a gift):
1-3 years @ 40% (full rate: 40%)
3-4 years @ 32% (20% taper relief)
4-5 years @ 24% (40% taper relief)
5-6 years @ 16% (60% taper relief)
6-7 years @ 8% (80% taper relief)
What are gifts with reservation?
In order for a gift to be effective for exemption from IHT, the person receiving the gift must get the full benefit of the gift to the total exclusion of the donor.
Otherwise, the gift is not a gift for IHT purposes. For example, if you give your house to your children, but continue to live there, without paying a market rent, then the house remains in your estate for IHT.
Decreasing term assurance
Decreasing term assurance can be arranged to cover the potential IHT liability during the seven year period following the gifting of a potentially exempt transfer.
Such policies should be written in trust, so that the proceeds fall outside your estate and paid quickly to your beneficiaries when you die.
Is business and agricultural property subject to IHT?
These are both exempt from IHT.
AIM shares, or shares qualifying as 'business property investments' in certain AIM-trading companies, or unquoted trading companies, can attract 100 per cent relief from IHT, provided that:
the investment is held for at least two years; or
before a chargeable transfer for IHT purposes takes place (such as a transfer to a trust), and they are still held by the transferee at the death of the donor, if within seven years.
Settling business property or agricultural property in trust could save the 20 per cent set-up charge on trusts (see below) and, with careful planning, AIM shares could also be used to avoid the 10 year anniversary charges on trusts.
WoodlandsWoodlands may be exempt from IHT, as commercial woodlands are from income and capital gains tax.
Pre-Owned Assets Tax
The Pre-Owned Assets Tax (POAT), which came into effect on 6 April 2005, clamped down on arrangements, whereby parents gifted property to children or other family members, while continuing to live in the property without paying a full market rent.
POAT is charged at up to 40pc on the benefit to an individual continuing to live in a property, which they have gifted, but are not paying a full rent and where the arrangement is not caught by the Gift with Reservation rules.
So anyone who has effected such a scheme since March 1986 could fall within the POAT net and be liable to an income tax charge of up to 40pc of the annual market rental value of the property.
Alternatively, you can elect by 31 January following the end of the tax year in which the benefit first arises, that the property remains in your estate.
Rental valuations of the property must be carried out every five years by an independent valuer.
Those doing equity release schemes are exempt from POAT, as are those whose home has an annual rental value below £5,000 (for a sole occupant) or £10,000 (for a couple).
What is the CGT position, if I gift property to an adult child?
If you wish to gift property to an adult child via a trust, you can elect to hold over the capital gains tax liability. Otherwise, CGT would be payable on such a transfer because it is effectively a gift of the property. However, no private residence relief will be available on a future sale.
How do I use trusts for IHT planning
A financial adviser will often suggest using a trust to preserve family wealth. A trust is basically an obligation binding a person called a trustee to deal with 'property' (assets) in a particular way for the benefit of one or more 'beneficiaries.'
Terms used when talking about trusts
Trust property: this can include money, investments, land or buildings and other assets.
The cash and investments held in the trust are called the 'capital' or 'fund' of the trust. This capital may produce income, such as interest or dividends. Land and buildings may produce rental income.
The 'settlor' is the person who creates the trust and puts property into it at the start or later on. The settlor states in the trust deed how the trust's property and income should be used.
The trustees are the 'legal owners' of the trust property and must deal with it in the way set out in the trust deed.
Beneficiaries are the individual/s who benefit from the property held in the trust. These are usually named individuals or members of the settlor's family. Different beneficiaries can benefit from the trust in different ways, i.e. from the income only, the capital only, or both.
A trust might be created in the following circumstances:
when someone is too young to handle their affairs;
when someone can't handle their affairs because they're incapacitated;
to pass on money or property while you're still alive;
under the terms of a will;
when someone dies without leaving a will (intestate)
Different types of trust
When writing a will, there are several kinds of trust that can be used to help minimise IHT liability. The Government changed some of the rules regarding trusts, which took effect from 22 March 2006 and introduced some transitional rules for trusts set up before this date.
A bare trust is one where the beneficiaries are named and cannot be changed.
You can gift assets to a child via a bare trust, which will be treated as a Potentially Exempt Transfer (PET) until the child reaches age 18, (the age of majority in England and Wales), when the child can legally demand his or her share of the trust fund from the trustees.
All income arising within a bare trust in excess of £100 pa will be treated as belonging to the parents (assuming that the gift was made by the parents).
But providing the settlor survives seven years from the date of placing the assets in the trust, the assets can pass IHT-free to a child at age 18.
Life interest or 'interest-in-possession' trusts'
With these trusts, the beneficiary/ies (sometimes called the life tenant/s) have a legal right to all the trust's income (after tax and expenses), but not to the property of the trust.
These trusts are typically used to leave income arising from a trust to a second surviving spouse for the rest of their life. On their death, the trust property reverts to other beneficiaries, (known as the remaindermen), who are often the children from the first marriage
With a life interest trust, the trustees often have a 'power of appointment' which means they can appoint capital to the beneficiaries, (who can be from within a widely defined class, such as the settlor's extended family), when they see fit.
Where an interest-in-possession trust was in existence before 22 March 2006, the underlying capital is treated as belonging to the beneficiary/ies for IHT purposes, i.e. it has to be included as part of their estate.
Transfers into interest-in-possession trusts on, or after, 22 March 2006 are taxable as follows:
20% tax payable based on the amount gifted into the trust at the outset, which is in excess of the prevailing nil rate band;
10 years after the trust was created, and on each subsequent 10 year anniversary, a periodic charge, currently 6%, applied to the portion of the trust assets, which is in excess of the prevailing nil rate band.
The value of the available 'nil rate band' on each 10 year anniversary may be reduced, for instance, by the initial amount of any new gifts put into the trust within 7 years of its creation.
There is an exit charge on any distribution of trust assets between each 10 year anniversary.
The charge is based on the following:
the length of time between the distribution of assets and the most recent 10 year anniversary;
the value of the assets being distributed; and
the effective rate of tax applied to the trust at the most recent 10 year anniversary.
If no tax was due at the most recent 10 year anniversary, then no tax will be due under the proportionate exit charge. In addition, if the trust has business or agricultural property, then the IHT reliefs for these types of property can reduce or eliminate the IHT charges.
Transitional rules apply to trusts established before 22 March 2006, so that in certain cases, for a new life tenant, the previous IHT treatment continues so that the trust funds are treated as belonging to the beneficiary/ies for IHT purposes.
Calculating the 10 year anniversary charge and the proportionate exit charges are extremely complex, and you are advised to seek professional advice.
With a discretionary trust, the trustees decide how much income or capital, if any, to pay to each of the beneficiaries - although no beneficiary has an automatic right to either. The trust can have a widely defined class of beneficiaries - typically the settlor's extended family.
Discretionary trusts are a useful way to pass on property while the settlor is still alive and allows the settlor to keep some control over it through the terms of the trust deed.
Discretionary trusts are often used to gift assets to grandchildren, as the flexible nature of these trusts allows the settlor to wait and see how they turn out before making outright gifts.
Discretionary trusts also allow for changes in circumstances, such as divorce, re-marriage and the arrival of children and step children after the establishment of the trust.
When any discretionary trust is wound up, an exit charge is payable of up to 6 per cent of the value of the remaining assets in the trust, subject to the reliefs for business and agricultural property.
Accumulation & Maintenance trusts
Accumulation and Maintenance (A&M) trusts which were already established before 22 March 2006, and where the child is not entitled to access the trust property until an age up to 25, could be liable to an IHT charge of up to 4.2pc of the value of the trust assets.
It has not been possible to create an A&M trust since 22 March 2006, for IHT purposes. Instead, they are taxed to IHT as discretionary trusts.
Trusts for vulnerable persons
These are special trusts, often discretionary trusts, arranged for a beneficiary who is mentally or physically disabled. They do not suffer from the IHT rules applicable to standard discretionary trusts and can be used without affecting entitlement to state benefits. Strict rules apply, so professional advice is essential.
Whole of life assurance
If, despite all your planning, you believe there will still be an IHT liability on your death, you could buy a purchased life annuity (out of your savings) and use the income to pay regular premiums towards a term, or whole of life, assurance policy.
This is known as a 'back to back' arrangement.
Alternatively, you could simply pay the whole of life assurance premiums out of savings. These policies should be written in trust so that they fall outside your estate and the proceeds paid quickly to your beneficiaries when you die.
On 9 October 2007, Alistair Darling introduced a new 'spousal exemption,' whereby married couples and civil partners can transfer all their assets on death to their spouse or registered civil partner free of IHT.
Prior to October 2007, without carefully drafted wills, a married couple, or civil partners, often failed to make full use of both IHT allowances to bequeath assets to children and other beneficiaries.
This was usually because there were not enough assets in the estate to do so or because they were unaware of the facility to write 'mirror wills.'
This means that a married couple or civil partners could bequeath up to £650,000 of assets to beneficiaries free of IHT in 2009-10, or £700,000 in 2010-11, without having to do complex estate planning or write mirror wills.
Since 9 October 2007, if the nil-rate band was not mopped up in full on the first spouse's death, it can be used on the surviving partner's death and crucially, up to the IHT threshold applicable in the tax year in which the second death occurs.
It is estimated that the change will benefit 12m civil partners, plus a further 3m widows and widowers. It would save a family £130,000 in 2009-10.
FAQs on the spousal exemption
Do non-married couples benefit?
No, the spousal exemption only applies to legally married couples and registered civil partnerships. However, non married couples can still use their individual £350,000 allowances (2009-10) to bequeath assets to each other and their heirs, but only if they have sufficient assets to do so.
The crucial difference is that a non-married couple cannot transfer more than the prevailing individual IHT allowance to each other on first death, without being subject to IHT.
My spouse died before 9 October 2007 and I haven't remarried. Do I benefit from these changes?
Yes, the legislation is retrospective. However long ago your spouse died, you should be able to use both allowances based on the nil rate band prevailing in the year of the second death. There are special rules for deaths prior to 21 March 1972.
For example, if your spouse used only half of their allowance for the year in which he or she died (for example, only £45,000 of the £90,000 IHT allowance was used in 1987-88), the remaining 50 per cent can be mopped up in the tax year of the second| death and added to the survivor's own exemption.
So if you were to die in tax year 2010-11, (when the IHT threshold for married couples is due to rise to £700,000), a total of £525,000 could be bequeathed to your beneficiaries free of IHT. This is made up of (£350,000 (your own allowance) plus £175,000 (50 per cent of £350,000 representing your deceased spouse's unused allowance).
I already have a will trust in place to make use of both allowances. Should I change it?
This is probably a nil rate band discretionary trust, which was set up when you wrote your wills, on the advice of a solicitor. If you and your spouse are both still alive, the trust will not have been created as these trusts only become effective on the death of the first spouse.
If the purpose of the trust was simply to use both spouses' nil rate bands, it is of no great use now and it may be cheaper to redraft your will to remove the trust, as it will be incurring annual management fees to keep it running.
Alternatively, your executors may be able to collapse it without the need to redraft your will.
My husband, who died some time ago, set up a discretionary will trust before his death. What are the implications for me and the other beneficiaries?
There is usually little you can do to alter the terms of such a trust, particularly if the beneficiaries are yourself and the children from a previous marriage. You could ask the trustees for advice, but the spousal exemption rules are unlikely to help in this case.