The issue of Inheritance Tax has come to the fore in the political arena over the last week. It is now clear, given the upsurge in the value of residential property in the UK over the last decade, that the prospect of so called “death duties” will influence the electorate as they decide where to pledge their support in the run up to the next General Election. This has been evidenced this week by the changes to the law implemented by Chancellor Alistair Darling in response to Shadow Chancellor George Osbourne’s proposed reforms of this area unveiled at the recent Conservative Party Conference Gary Patterson now takes the opportunity to examine this area in detail….
What is Inheritance Tax?
Inheritance Tax (IHT) is payable on a person’s death if the value of their estate exceeds the threshold limit set by the government. This is currently £300,000 but is set to rise to £350,000 within three years. For IHT purposes a person’s estate is taken to be all of their assets including their interest in any jointly-owned property. In addition, the value of any gifts made by the person in the seven years before their death is also taken into account. Tax is payable at a rate of 40% on any amount over the threshold limit. In other words, the first £300,000 of a person’s estate is tax free. However any additional amount will be taxable and given the relatively high rate of tax payable this can often result in substantial amounts having to be paid to the Revenue.
What are the changes that have been made?
The £300,000 threshold has not increased. However, married couples or civil partners will now be able to transfer the unused element of their IHT-free allowance to their spouse when they die. For many couples this will effectively double the tax-free amount they can bequeath to their children. For example, if a husband dies and leaves all his assets to his wife, she will be able to bequeath up to £600,000 tax-free to her children. The £600,000 is made up of her and her late husband’s joint IHT-free £300,000 allowances. To illustrate this, if a married couple has joint assets of £500,000, when the husband dies and leaves his share to his wife she can pass on these assets to her children tax-free when she dies. Previously, the Treasury would have taken £80,000 from the couple’s estate. The rules will be backdated indefinitely so any widows or widowers will be able to use their late partner’s IHT-free allowance as well as their own when they die. Unfortunately IHT will still be levied at 40 per cent above £300,000 on the estate of anyone who is single or divorced when they die.
Mitigation of IHT
The new rules will mean that many couples will no longer pay any IHT on their estates. However for those who are single or co-habitees who have chosen not to get married or enter into a civil partnership and indeed couples who have assets greater than £600,000, there may still be potential for an IHT liability.
There are measures that can be taken to mitigate a person’s IHT liability. Careful tax planning during a person’s lifetime and on death (by virtue of a well drafted Will) can reduce and in some circumstances avoid any IHT liability.
In simple terms the measures that can be taken are aimed at reducing and maintaining a person’s estate at a level that is manageable and that will attract as little tax as possible on death. However given the upsurge in the value of residential property in the last decade many people find themselves in the bracket where IHT would be payable without having that many liquid assets.
If there are readily disposable assets that could be transferred to reduce a person’s estate it is imperative that the correct balance is achieved between reducing one’s assets to a sensible level for tax purposes and leaving oneself financially secure.
Another issue to consider if transfers of assets are being contemplated during a person’s lifetime is the possibility of a Capital Gains tax liability. Specific advice should be sought on this point before any transfer is effected.
Steps that can be taken during a person’s lifetime
These steps have been summarised below and generally involve the disposal of assets to other family members etc-
Annual Exemptions
A person can make gifts of up to £3,000.00 in each tax year. If no gift has been made in the previous tax year a total of up to £6,000.00 can be gifted.
Small Gifts Exemption
Also, during one tax year, a person can give sums of up to £250.00 to any number of beneficiaries.
Potentially Exempt Transfers (PETs)
Larger amounts can be given away at any time and if the person making the gift (The Donor) survives for a period of seven years after the date when the gift was made the gift will become exempt and not be included in the person’s estate on death. Generally speaking if a large gift is to be made it is better that it is done sooner rather than later so that “the clock can begin to tick” on the seven year period.
Gifts out of Income as part of ‘usual expenditure’
Unconditional gifts that form part of a person’s usual expenditure which are made out of income as opposed to capital and leave the person with sufficient income to maintain his or her normal standard of living are exempt from IHT.
Gifts in contemplation of Marriage
A person can give away £5,000.00 in any tax year to a child who is getting married in that year. This amount would be exempt from IHT immediately. Lesser amounts can be gifted to remoter relations.
Recording Gifts and Transfers
It is advisable to take a careful note of all gifts and lifetime transfers. Typically the nature of the gift, the date on which the gift took place and the value of the asset should be recorded. Formal valuations rather than approximations would be preferable.
Insuring against IHT liability
It is possible to take out a policy of insurance which will pay out on a person’s death and be sufficient to meet their IHT liability. The premiums on such policies can be very expensive and advice should be sought from an appropriately qualified person in relation to same.
Pension Death Benefits/Death in Service Benefits
If you are a member of a pension scheme that pays out a lump sum on your death it is possible to nominate who you wish to obtain this payment. In some circumstances it may be appropriate to nominate someone other than your spouse as this payment may actually increase potential IHT liability. You should contact your pension company or financial adviser for further advice on this.
Transfers of Property on Death
Gifts, on death, to spouses, charities and political parties are completely exempt and are therefore not included in a person’s estate for IHT purposes. There can also be some relief from IHT liability in relation to agricultural or business property on death.
Trusts
What is a Trust?
A trust is an arrangement by which property is held by one or more individuals (the Trustee(s)) for the benefit of others (the Beneficiaries). Trusts can be set up during a person’s lifetime by way of a trust deed or on death under a will. The trust instrument will contain whatever provisions are considered appropriate in the circumstances. For example, it can be stipulated at what times and in what proportion the funds can be used having regard to the needs of the beneficiaries. It is usual to have at least two trustees. There is nothing to prevent the person who is setting up the trust from acting as a trustee. Many people prefer to set up a trust rather than making an outright gift to a beneficiary.
How can Trusts be used to avoid or minimise IHT?
A simple example of trusts being used to protect family wealth would be the situation where a person’s adult children are financially secure and trusts are set up in favour of grandchildren in order to “skip” a generation. This can avoid the situation where gifts to the adult children would actually cause them a problem from an IHT point of view. The trusts would stay in place until the grandchildren became adults or until they reached the age specified in the trust instrument.
Special types of trust can be used to provide flexibility in relation to tax planning. The most common example of this is a discretionary trust. This is an arrangement where a class of beneficiaries is identified in the trust instrument rather than specific named individuals. The trustees have discretion as to which beneficiaries within the class actually benefit and by how much. In other words none of the beneficiaries have an absolute right to benefit under the trust and it is the responsibility of the trustees to decide how the fund is applied. However the individuals setting up the trust cannot themselves be included in the class of beneficiaries.
The advantage of this type of arrangement is that the trustees have a great deal of flexibility. If a discretionary trust is included in a will funds can be left to a wide class of beneficiaries such as the spouse of the person making the will, their children and their grandchildren (including unborn grandchildren). Depending on the circumstances it can be useful to be able to exclude certain members of the class of beneficiaries from receiving any benefit under the will and the discretionary nature of this particular type of trust will permit this. For example if the spouse is financially secure funds can be diverted away from them so as to reduce their own potential liability to IHT. In other words you do not have to predict the financial position of the spouse at the time of the first death. You can simply wait and see what the exact circumstances are and distribute the estate accordingly.
Insurance Policies in Trust
It is also possible to ‘write’ life insurance policies in trust. This simply means that instead of the proceeds of the policy being paid to a person’s estate on death they are paid to a nominated Trustee for the benefit of the person’s chosen beneficiaries. This is often an effective method of minimising the potential tax liability. It is prudent to contact the insurance company directly as often they will have a standard form of trust deed which will need to be completed.
Taxation of Trusts
Specific advice should be obtained from an accountant at the outset in relation to the taxation of a trust. The creation of a trust will raise issues in relation to IHT, income tax and capital gains tax.
It should be noted that if a trust is set up during a person’s lifetime the initial contribution (save the annual £3,000.00 exemption) would be subject to the seven year time limit and would only become exempt once this period had elapsed. This would also apply to any subsequent contributions to the fund over the annual exemption threshold. Additionally depending on the type of trust there may also be tax charges on the trust fund at regular intervals or when the trust is wound up. Also if investments are contributed to the trust fund that were worth more than when they were originally acquired there may be a capital gains tax liability. Again, specific advice would need to be sought on this point.
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