Inheritance tax is no longer just the scourge of the very rich. Rising house prices and the Government’s raising of the level at which an estate escapes inheritance tax means that more and more of us are paying it. Here’s how to minimise your tax bill.
While sweeping more people into the IHT net, this Government has also made it harder to avoid paying the tax. New rules that come into effect in April this year – the pre-owned assets legislation – mean many IHT avoidance schemes will no longer be worthwhile. There are still ways to reduce your tax bill, but it needs careful planning. After all, elderly parents need something to live off themselves and are loath to make irreversible decisions. For instance, it is only too common for parents to hand over large gifts, or even houses, to children, says Neasa MacErlean in The Observer, only to find those children divorcing and half the value of the asset being given to the estranged spouse.
Get married
Tax barrister Emma Chamberlain’s most basic piece of advice is to “marry and make a decent will”. Assets left to a spouse, regardless of value, are never taxed and when the Civil Partnerships Act takes effect, cohabiting same-sex couples could get the same exemption. Those penalised under the current system are heterosexual cohabitees. In terms of passing assets to others, couples should ensure they take advantage of both nil-rate bands, after which tax is payable at 40%: so a husband should leave assets up to £263,000 to his children, and the remainder of the estate to his wife. When the surviving spouse dies, they can also leave £263,000 tax free.
Be generous
Give away as much as you can during your lifetime. In theory, anything you give away could create an IHT liability, but most of these ‘lifetime transfers’ are either fully or potentially exempt, in which case they are called potentially exempt transfers (PETs). PETs are so-called because the transferor has to survive for seven years after making the transfer for it to become fully exempt of any IHT (subject to the gifts with reservation rules – see below). Because the seven-year rule is absolute, it is vital to have documentary evidence to prove the date the transfer was made. There is also some relief where death occurs more than three, but less than seven, years after the transfer.
You are also entitled to give money or assets away without having to start the seven-year clock. Everyone is entitled to an annual exemption allowance of £3,000, which means that you can give away a total of £3,000 each year tax-free. These transfers are called absolute exemptions, and are not dependent on whether you survive for any particular period. If you fail to used this annual exemption one year, it may be carried forward and used in the next tax year. Gifts in consideration of marriage are also tax-free: parents are allowed to give up to £5,000 each, and grandparents up to £2,500. Should you want to give money to a national charity, an institution such as the British Museum, or a political party, you can do so, alive or dead, 100% tax-free.
If a transferor has a large income and wishes to give it away, there is nothing to stop him or her from doing so. Such lifetime transfers of value are exempt from IHT, as long as it can be shown that the gifts are part of their “normal, habitual expenditure”, are made out of income, not capital, and that the transferor is left with sufficient net income to maintain his or her usual standard of living. This is an “extremely useful exemption”, says Carl Bayley, author of How To Avoid Inheritance Tax, “since, unlike the annual exemption, there is no financial limit to the amount which can be covered by this exemption if the transferor can afford it”.
Potentially, therefore, you could give your son £10,000 every year, pay your nephew’s school fees, or give your daughter all your ICI dividends every year. As a rule of thumb, it has been suggested that the Capital Taxes Office (the Inland Revenue department responsible for policing IHT) does not usually ask questions if gifts do not exceed a third of the transferor’s annual income. However, in some instances – for example, in the case of an extremely wealthy person with a very frugal lifestyle – it may be possible to justify far larger gifts. It is important to establish that the gift was “habitual”, whether it was annually or every few years, to make sure that it is not pulled back into your estate for IHT purposes when you die.In some instances, a letter of intent is sufficient. For example, if you did want to pay for your nephew’s school fees, you should write to the school confirming the fact. Then, if you happen to die a year into their schooling, the first set of fees will be exempt from IHT.
Keep no beneficial interests
The above makes tax avoidance sound easy, says Bayley. All you have to do is give everything away and survive for seven years (and you can even take out insurance to cover the risk of dying sooner). But there are “some catches”. One of the most significant of these is that gifts where the transferor retains a beneficial interest in the gifted asset – known as gifts with reservation – are still treated as part of his or her estate for IHT purposes.
Although experts had worked out sophisticated schemes, such as double trusts and life interest, to sidestep the gift with reservation rules while effectively enabling parents to give their house away to their children and continue to live in it, the new legislation on pre-owned assets, which comes into effect on 5 April this year, aims to put a stop to this. While it is too early to tell what the exact implications of this new legislation are, essentially the Government plans to regard assets that have been given away as producing a notional annual income and taxing donors on this income at their highest marginal rate. In the above instance of a house that has been given to children, the figure used would be the going rental rate for the property. This legislation will affect any such gift made since March 1986.
If you have one of these schemes already in place, you have three options, says David Budworth in The Sunday Times. You can either leave the scheme in place and pay an income-tax charge on an assumed market rent, which would mean your heirs would still avoid IHT; or you could leave the scheme in place, but register with the Inland Revenue so you avoid the income tax charge, leaving your heirs liable for IHT; or dismantle the scheme, which could be costly, and would still leave you liable for IHT.
To get around this “appalling” new piece of legislation, you would, in an ideal world, move out of the house and then give it away, says Bayley. The gift then counts as a PET, which will escape any inheritance tax as long as you survive seven years. As long as you make the gift within three years of moving out, it will also be exempt from capital gains tax under the principal private residence relief rules. If you are prepared to do this, you could then move into rented accommodation or buy a house worth less than £263,000. But this isn’t usually a workable solution. Emma Chamberlain suggests either a co-ownership arrangement or an equity release scheme. Under a co-ownership arrangement, an ageing parent could, say, give a share of the family home to a daughter and as long as the daughter continues to live there and the two share expenses, there is no IHT to pay if the parent survives seven years after making the gift. Nor would the mother have to pay income tax, as this arrangement is outside the pre-owned assets legislation. The other option is for the parents to sell the house to the children at full market value and then continue to live there. The cash they receive will fall into their estate for IHT purposes, but they can choose to give it away to other family members (not the children who bought it) at a later date. Stamp duty land tax is payable on the sale.
Be a farmer
If your home happens to be a farmhouse, you should escape IHT altogether, providing there is land attached and agricultural activities are being carried out on that land at the time of the transfer. Indeed, most family businesses can be passed on free of tax, says Bayley, which means that, “from a tax perspective, the last thing a dying person should do is sell their business”. A raft of criteria must be met to qualify for agricultural and business property relief, so should you fall into either of these categories, you need to examine your affairs very closely.
Create a trust
Lastly, a trust – such as an interest in possession trust or a discretionary trust – may be useful in inheritance-tax planning. Discretionary trusts, for instance, are treated as separate persons for IHT purposes and provide the opportunity to shelter assets worth £263,000 every seven years. However, you must ensure that it is impossible for either the transferor or their spouse to benefit from the trust to avoid the gift with reservation rules. Since there are many pitfalls for the unwary, you should take professional advice.
How To Avoid Inheritance Tax by Carl Bayley is available for £19.95 from www.taxcafe.co.uk. Pre-Owned Assets by Chris Whitehouse and Emma Chamberlain, Sweet & Maxwell, £125.