How to save money on Inheritance Tax

Inheritance tax is a constant source of interest to those subject to it, and debate abounds as to its appropriateness, though that deserves an article of its own and is outside the scope of this piece.

Famously described by a former Labour party shadow chancellor, Roy Jenkins, as “a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue”, IHT is paid by only 4 per cent of estates.

Jenkins’ aphorism is proved somewhat by the recent news that TV presenter Anne Robinson has reportedly given away a £50mn fortune to her family to mitigate the IHT liability that would otherwise arise on her death.

Following the reporting of Robinson’s gifts, readers with estates worth more than the IHT tax-free threshold of £325,000 (£650,000 for married couples/civil partners, and up to £1mn when taking into account the additional and complex residence nil-rate band [RNRB]) may well be wondering whether they too can mitigate the tax.

Is it as easy to do as simply ‘giving away’ money?  What are the risks involved in making such gifts? Are there other methods by which they could reduce their IHT exposure?

To best answer these questions, it is important to understand some of the fundamental principles of IHT and how it is charged.

IHT is extraordinarily technical and complicated, and readers can be forgiven for glazing over when immersing themselves in its details. But the technical nature of the IHT regime, by design, creates both opportunities and traps for taxpayers.

In most cases, IHT is associated with and levied on death.

Broadly, the tax is charged at 40 per cent on the value of an estate over the £325,000 nil rate band, with an additional RNRB if the deceased’s home is passed to direct descendants (children and grandchildren), though only if the deceased’s gross estate is valued at less than £2mn.

If the value of the individual’s estate exceeds £2mn, the RNRB is tapered, and removed entirely for estates worth £2.25mn.

In the case of married couples/civil partners, IHT is generally not payable on the first death provided that the assets pass to the surviving spouse/civil partner, thereby deferring a tax charge and its consequent cash flow disadvantage until the second death.

Technically, IHT is charged on ‘transfers of value’, being any ‘disposition’ which reduces the value of the transferor’s estate – including gifts.

Navigating potentially exempt transfers

Gifts can enable an individual to circumvent IHT if he or she survives each one by seven years, hence they are called potentially exempt transfers (PETs) in an IHT context.

If the transferor dies within three years of making a PET, the full value of that gift is treated for IHT purposes on his/her death as if it was still in the estate and taxed as such.

If the transferor survives the gift by more than three years then the rate of tax is tapered by 20 per cent each year, until after seven years it falls out of charge entirely.

As such, making simple outright cash gifts to family members and surviving them by seven years is typically the most straightforward way of reducing one’s IHT liability. However, various anti-avoidance rules can cause traps for the unwary.

Most importantly, it is imperative that the donor does not continue to benefit from assets given away.

If a benefit is retained, the ‘gift with reservation of benefit’ (GROB) rules provide that the full value of the assets will be treated as remaining in the IHT estate of the transferor notwithstanding the gift.

Only if the donor subsequently ceases to retain a benefit during his/her lifetime would the seven-year clock commence for the gift to fall outside the taxable estate.

The significance of PETs is that there is no limit on the amount an individual can give away.

This is enormously valuable, and PETs are almost always a part of every effective estate planning strategy.

PETs do come with risks, though. The most immediate obvious risk is that the donor might die within the seven-year period, thus triggering IHT – though life insurance policies are available to mitigate that potential exposure.

Other risks also arise. First, the donor must not give away too much, in case he/she finds later in life that they have kept too little for themselves.

Secondly, there are no controls on how outright gifts are used by the recipient, and solicitors regrettably see the consequences of young people being given too much too soon all too often.

Thirdly, assets given outright are available to the recipient’s spouse on a divorce, though that risk can be mitigated by the use of a nuptial agreement – a so-called pre-nup or post-nup.

While PETs are invaluable, they by no means exhaust the arsenal of IHT planning opportunities, and a good strategy will seek to use many or most of them to chip away at IHT liabilities insofar as appropriate.

Using a trust

Historically, trusts were commonly used to give away the benefit of assets while still retaining control over their use by acting as a trustee, and trusts are still the most flexible and appropriate structure in countless cases.

However, changes to the taxation of trusts in 2006 make their use less common now. They can be used to give away an amount up to the NRB – so £650,000 for a married couple – without an up-front charge to tax, and as the NRB refreshes every seven years, that amount can be given to a trust every seven years.

Trusts can also be used for tax-relieved assets, such as farmland or shareholdings qualifying for business relief, for example, with no tax on the gift.

Another valuable and under-used relief is for gifts of surplus income, i.e. income not needed to sustain the donor’s lifestyle and needs.

Those gifts, which can be outright or to a trust without regard to the NRB, fall immediately outside the donor’s taxable estate, and there is no need for him/her to survive by seven years.

There are a few qualifying conditions in order to satisfy this requirement.

First, the gift of income must be made as part of the normal expenditure of the donor.

HMRC explains this condition: the gift should form part of a “regular pattern of payments” – a covenant (a legally binding promise) to make such payments in future can be useful in evidencing the intention of meeting this condition.

Secondly, the donor must retain sufficient income to maintain his/her “usual standard of living”.

If necessary, an income and expenditure analysis should be undertaken each year to be satisfied that this criterion is met.

Finally, the gift must be made out of income. This means that the funds must have arisen from a salary, pension income, rental income, dividend payments, for example; conversely, it cannot be made from capital (eg savings).

Given the need to satisfy HMRC that all of the requirements of this relief are met in the event of the donor’s death, it is almost always sensible to keep detailed records any gifts made in reliance on it, including the source of funds, value of the gift and information about the recipient(s).

A little-known exemption to the GROB rules, with the un-catchy name ‘section 102B’, concerns the gift of an undivided share in land – commonly, a holiday home used by several members of the family.

This exemption allows the donor to give away part of his/her interest in the property to others, typically up to 75 per cent, though the exact share is not set in stone, but still to occupy the property without breaching the prohibition on retaining a benefit in the GROB rules.

Of course, the gift will still be considered a PET and the donor must survive the seven-year period for the value of the share of the asset to fall outside the estate.

This can be an effective way of passing down ownership of part of a family property for tax reasons while retaining its use and a degree of control.

The above strategies by no means exhaust the IHT planning opportunities open to taxpayers, many more not covered here are often implemented within two years of a death occurring.

On the basis that the particular statutory criteria are satisfied, it is possible to vary the disposition of a deceased’s estate and for the variation to be ‘read-back’ into the will for IHT and/or capital gains tax purposes.

This means that the variation is treated as if the disposition is from the deceased’s estate rather than from the beneficiary making the variation, which is often tax-efficient if it enables the original (taxable) recipient of a legacy to re-direct it without giving rise to other tax considerations.

Variations are most commonly used to increase the tax efficiency of an estate where the IHT reliefs have not been maximised.

Perhaps the simplest of the reliefs or exemptions is the annual exemption.

Transfers are exempt in the value of up to a total of £3,000 in each tax year for IHT purposes.

It is possible to carry forward any unused annual exemption to the following tax year. It is only possible to carry forward the annual exemption by one tax year.

Possible changes?

During the course of their election campaign and in their manifesto, the Labour party announced significant changes to the taxation of non-doms, which built on previously announced Conservative plans, though these do not necessarily involve wider changes to the fundamental structure of the IHT regime, which has been in place since 1975.

That said, the technical difficulties inherent in enacting Labour’s proposed non-dom changes are such that a more wide-ranging IHT rewrite is certainly possible.

In parallel, there have been calls by some for the introduction of a gift tax and/or an annual wealth tax, either of which might affect taxpayers’ views on IHT planning if implemented.

Given the current law in force and the potential for radical changes in the near future by the newly incumbent Labour government, perhaps now more than ever, our advice to our clients remains that they should review their current tax affairs and take advice from a specialist solicitor on their options.

We can also discuss how some investments would allow funds to fall out of an estate after only two years….but that is a read for another day.