Your five-minute guide to inheritance tax planning – part 2
First published 12 July 2016 • Updated 13 March 2018
In part 1 we covered the basics of inheritance tax and how to reduce it acceptably by making gifts before your death. In part 2, Chartered Financial Planner Michael Roberts delves a bit deeper into some of the more complex areas – where you should definitely look both ways before crossing.
The basic principle of reducing inheritance tax (IHT) sounds simple enough: by giving away assets during your lifetime, you can steadily reduce the size of your estate and hence the amount that is vulnerable to inheritance tax. Indeed, if you can reduce its size to within your nil-rate band (see part 1) then you will not be liable to IHT at all.
However, rules exist to prevent you from simply giving away all your assets during your lifetime. There is a limit to the size of the gifts (and how close to your death you can make them), so you need to plan carefully if you want to stay within these limits. There are also certain assets that may be exempt from IHT. Similarly, certain transfers of assets can be subject to an IHT charge right away – so all of the areas below are definitely a case for seeking professional advice before taking action.
Chargeable lifetime transfers
Gifts into certain types of trust are classified as chargeable lifetime transfer. As the name suggests, these can be subject to an immediate charge to IHT. Although not all such transfers will actually be chargeable, this is a highly complex area where the specific circumstances must be taken into account to determine whether IHT is due.
Potentially exempt transfers
If a gift is made that does not qualify as an exempt gift (see part 1), and it is not a chargeable lifetime transfer either, then it is likely to be a potentially exempt transfer (PET).
For example, Andrew gives his son Stuart £30,000 as a deposit on his first home. Andrew has told Stuart that the money is his to keep, i.e. he doesn’t need to repay it. As this gift does not fall into any of the exemptions described above, and because Andrew has already used his available annual exemptions, this gift to Stuart is a PET.
Providing Andrew survives 7 years or more, no IHT will arise on this gift. However, Stuart should be careful, because he may be liable to pay IHT if Andrew dies within 7 years of making the gift.
Again, calculating whether any IHT is due is a complex issue and requires further investigation.
It is not necessary to report PETs to HMRC, but it is very important to keep proper records of such transactions. If the donor does dies within 7 years, a calculation will be carried out to determine whether any IHT is due on the gift. If IHT is due, taper relief can be applied to reduce the amount of tax to be paid, if the donor died more than 3 years after the gift was made.
If you make a gift of this kind, then there is something else to bear in mind too. You must not continue to receive any benefit from the assets given away – for instance, you cannot transfer ownership of your house to your child but continue to live in it rent-free. Otherwise, it may be classed as a ‘gift with reservation of benefit’, with the gifted asset then being treated as remaining within your estate for IHT purposes.
Certain types of assets qualify for advantageous treatment for IHT purposes. One example of this is business assets which qualify for business property relief (BPR).
BPR is an extremely useful planning tool for IHT, especially for business owners (but for other people too). In essence, BPR allows an individual to pass on certain business assets free of IHT either during their lifetime or upon death.
Here are some examples of assets which may qualify for BPR:
- A business, or an interest within a business
- Unlisted shares, including those listed on AIM
- A controlling shareholding in a company listed on a recognised exchange
- Land, buildings, plant and machinery used wholly or mainly within the donor’s business in the last two years
There are a number of exclusions from this relief, including companies which deal mainly in securities, stock, land or buildings, or making or holding investments. If you think you might want to take advantage of BPR in any way, then it is important to seek professional advice.
Warning! Take care when disposing of BPR-qualifying assets
When considering your IHT position, you should be careful to take into account possible disposals of assets which currently qualify for BPR.
Consider the case of John. He owns a very successful mail order company, and his assets are made up of a house worth £300,000, plus the business which is valued at over £1m. His IHT position was reviewed recently and he was advised that his estate would not be subject to IHT because his personal assets are within the nil-rate band. Meanwhile his business assets are exempt from IHT because they qualify for BPR.
Soon afterwards, John becomes ill and decides to sell his business and retire. After paying capital gains tax on the sale of his business, he received a cash lump sum of £1m. A year later, he dies – and at the time of his death, his estate is subject to a significant IHT bill. This is because he sold the business (which had been exempt from IHT whilst he owned it), and received a large amount of cash in return – the cash no longer qualified for BPR. As his nil-rate band has already been used up by his house, the entire proceeds from the sale of his business are now subject to IHT at 40 per cent. The resulting tax bill is an eye-watering £400,000 – nearly half the value of the sold business. However, if John had sought advice then the BPR could have been retained, eliminating the whole of that £400,000 bill.
Don’t get caught out needlessly
Many people believe that only the richest pay IHT. The reality is that owning even a fairly modest property in a desirable area, plus some rainy-day money, may be enough to push you into the taxable band. In 2017 an additional nil-rate band will be introduced, applying to your main residence only, and this will protect many people to some extent – but with property prices continuing to rise, IHT will remain a big issue for many people.
Although there are numerous complex schemes available for reducing IHT, it is possible to cut or even eliminate your IHT bill just by using the simple reliefs and allowances, and by carrying out some basic planning. The solution begins with understanding the extent of any IHT that your family may have to pay in the event of your death. From there you can design an effective strategy to reduce the amount of tax payable.
Before you take any action, however, it’s important to seek advice on how the reliefs and exemptions above apply in your own personal circumstances. You can search for an adviser to help you do this using the smart postcode search on Unbiased.
About the author
Michael Roberts is a Chartered Financial Planner with Protect and Invest Ltd, a small firm based in Newbury and covering the Thames Valley. They specialise in retirement planning, investments and estate planning.
Important note: This article is for information purposes only and should not be considered to be a recommendation. This article is based on our understanding of current and draft pension and tax rules on the date of this article. Please note that tax and pension rules are subject to change; if you are at all uncertain about the suitability of any option for your circumstances you should seek regulated personal financial advice. You should not take action solely on the basis of this article without seeking advice specific to your circumstances.