Inheritance Tax reduces the amount of your estate which you would like to pass on when you die. With a tax rate of 40% the imposition of Inheritance Tax can seriously impact how much your heirs will benefit and if your wealth is in illiquid assets this can mean property must be sold to fund the tax and causes the breakup of estates.
The good news is that there is much that can be done to reduce the impact of Inheritance Tax given time and careful planning. The following are general principles which can be applied to achieve that end.
How Inheritance Tax works
On your death your estate is valued and tax is levied at the appropriate rate. The first £325,000, the nil rate band, is tax free and the excess is subject to tax at 40%. Gifts during the seven years prior to death may reduce the nil rate band or create an additional tax liability.
Transfers to your spouse are tax free and you can claim the nil rate band of a pre-deceased’s spouse if they didn’t use it. If your estate is worth less than £2 million you may be able to claim a further nil rate band of up to £175,000, or the value of your home if lower, provided certain conditions are met.
Overall a married couple could have an estate of up to £1 million and not pay any tax (two nil rate bands at £325,000 and two residence nil rate bands at £175,000) It is when your estate exceeds these parameters that tax planning become more relevant.
Making a Will
As a first step we recommend that everyone makes a Will, whether or not they have an Inheritance Tax problem, to make it clear how your estate is to pass to your heirs. Without a Will the rules of intestacy apply which may not give the result you would like. Whilst your beneficiaries can correct your Will by a deed of variation in many circumstances, it is much better for them not to have to do this.
Saving tax by reducing the value of the estate
Inheritance Tax is levied on you estate at death with lifetime gifts made more than seven years before you die generally not subject to this tax. The exception is a lifetime gift into a trust which may incur a half rate of tax at 20%.
A lifetime gift must be entirely unfettered. You cannot reserve a benefit from the item given away. For example you cannot give away your house but stay living in it, unless you pay full market rent. Whilst you might not want to pay Inheritance Tax you don’t want to make yourself destitute in the process which may limit the amount of lifetime gifts.
If your heirs are still young you may not wish to give them unfettered access to significant capital assets that you have worked hard to build up. This is when a trust comes into play as an interim step between removing an asset from your estate and putting it into the hands of others. Trusts have their own tax regime and the implications of setting up a trust must be properly understood from the outset. In some circumstances a family investment company may be used as an alternative to a trust structure.
There are some additional reliefs for lifetime gifts including, in brief;
- £3,000 annual allowance
- Small gift exemption – up to £250 per recipient
- Gifts in consideration of marriage – up to £5,000
- Habitual gifts out of surplus income
- Gifts to charity
Inheritance Tax planning cannot be considered in isolation. Action taken to mitigate Inheritance Tax may have other tax implications which need to be considered. For example the lifetime gift of property may save Inheritance Tax but may also be subject to Capital Gains Tax.
Changing the composition of the estate
There are presently two very significant Inheritance Tax reliefs for agricultural and business property. This provides an opportunity to change the composition of the estate so that these reliefs can be claimed. In this way you can continue to benefit from the assets in your estate which will then pass on to your heirs without any Inheritance Tax.
Whilst this relief is primarily applicable to active businesses it an also applies to passive investments in private trading companies and agricultural property which is let to farmers. Specialist investment advisers offer portfolios of shares in qualifying companies to take advantage of business relief.
Many people have the largest part of their wealth invested in a business with the plan to sell it and live off the proceeds in retirement. Whilst the business is active it may be covered by relief but following sale the proceeds may be chargeable to Inheritance Tax pre-emptive action before the business is sold may be appropriate to mitigate this effect.
An alternative route to provide for your heirs may be through a pension scheme. These are mostly now exempt Inheritance Tax and have flexibility to provide a variety of family benefits.
A special conditional relief may be available for heritage property and trust funds set up for their maintenance. If you own property which has particular historic, cultural, or scientific significance your heirs may apply for conditional exemption. This requires a degree of public access but can be a useful means to prevent the breakup of historic estates.
Inheritance Tax planning is a long term strategy which will benefit your family and heirs many years into the future. Whilst any tax can change over time, sensible strategic planning can help to ensure your assets pass to those you wish with the minimum of tax.