Inheritance tax

How can I mitigate IHT?

There are various exemptions (shown below) which enable you to reduce the size of your estate during your lifetime, but these should be used with care. Once you have gifted away money or property, you cannot continue to make use of it and still claim exemption from IHT.

1. Make a will

Your starting point for IHT planning should always be to write a will and review it every few years to check that it still reflects your wishes and current financial circumstances.

If you die without a will, your unmarried partner could end up with nothing, and even lose the home you lived in together. Even if you were legally married, your surviving spouse may only receive a limited amount from your estate and might have to sell the family home. Divorce, or dissolution of a civil partnership, could cause parts of your will to be nullified. A very important point to note is that marriage or remarriage will invalidate a current will.

A will allows you to:

• Direct who receives your assets – in the absence of a valid will, the intestacy rules dictate how much your spouse/ civil partner and wider family receive;
• Pass your estate to someone other than a spouse or civil partner who might otherwise inherit everything under the current intestacy rules;
• State whom you wish to be the guardians of your children;
• Make IHT-free legacies to charities and national institutions;
• Bequeath individual possessions to close friends or family members.

If you change an existing will, it is generally a good idea to start the new one with a clause stating that it ‘revokes all previous wills’.

2. Exempt transfers

Exempt transfers are gifts of various amounts which can be made during your lifetime to various beneficiaries with no IHT liability. Such gifts should be recorded – particularly ‘gifts out of surplus income’ – so that the executors of your estate can prove to the taxman that these were genuine tax exempt gifts.

For instance, gifts out of surplus income must:

• Be regular payments from your income
• Not have a detrimental effect on your normal standard of living.

What transfers (gifts) are exempt from IHT?

There are certain transfers or gifts which are exempt from IHT, these are:

• All transfers between UK domiciled spouses/registered civil partners
• (but only £55,000 if your spouse is non-UK domiciled);
• Gifts to charities and political parties;
• Gifts to national institutions (e.g. National Trust);
• Regular ‘gifts out of surplus income’ (which do not affect your standard of living);
• Small gifts of up £250 pa to any number of individuals;
• A £3,000 pa in total to any individual/s (e.g. £1,000 to each of three children, or £3,000 to one child). This £3,000 exemption can be rolled over for one tax year, but cannot be combined with other gifts;
• A £5,000 gift from each parent to a child on marriage/ civil partnership;
• A £2,500 gift from each grandparent (or remoter ancestor), to a grandchild on marriage/civil partnership;
• A £1,000 gift from any other person on marriage/ civil partnership.

3. Potentially exempt transfers (PETs)

Gifts, which do not fall within the above list of exempt transfers/gifts are unlimited gifts and can be made during your lifetime to any individual, but will only be free of IHT if you survive seven years from making the gift. Hence the name, ‘potentially exempt transfers’ or PETs

If you die within seven years, the IHT payable is calculated using a sliding scale, known as ‘taper relief’. This ranges from the full IHT rate of 40% in the first three years, to 8% in the seventh year, chargeable on any excess over the nil rate band.

Effect of taper relief:

4. Gifts with reservation

In order for a gift to be effective for exemption from IHT, the person receiving the gift must get the full benefit of the gift to the total exclusion of the donor. Otherwise, the gift is not a gift for IHT purposes. For example, if you give your house to your children, but continue to live there without paying a commercial market rent, the house remains in your estate for IHT.

5. Decreasing term assurance

Decreasing term assurance is life assurance for a fixed period of time or specified age but where the sum assured decreases each year. At the end of the term the sum assured has decreased to zero and the policy comes to an end without value.

It can be arranged to cover the potential IHT liability during the seven year period after making a potentially exempt transfer/gift. Such policies should be written in trust, so that the proceeds fall outside your estate and can be paid quickly to your beneficiaries when you die.

Is business and agricultural property subject to IHT?

Yes, both are exempt from IHT.

6. AIM shares

These are shares qualifying as ‘business property investments’ in certain AIM-trading companies – or unquoted trading companies – that can attract 10% relief from IHT, provided that:

• The investment is held for at least two years or before a chargeable transfer for IHT purposes takes place (such as a transfer to a trust)
• They are still held by the transferee at the death of the donor, if within seven years.

7. Businesses and agricultural property

Reliefs are available to enable businesses, farms and buildings, to be passed on in your lifetime free of tax. Woodlands (the value of the timber not the land) are exempt from IHT.

8. Pre-owned assets tax (POAT)

Came into effect on 6 April 2005 and clamped down on arrangements, whereby parents gifted property to children or other family members, while continuing to live in the property without paying a commercial market rent.

POAT is charged up to 40% on the benefit to an individual continuing to live in a property, which they have gifted, but for which they are not paying a market rent and where the arrangement is not caught by the gift with reservation rules (see point four).

So anyone who has affected such a scheme since March 1986 could fall within the POAT net and be liable to an income tax charge of up to 40% of the annual market rental value of the property. Alternatively, you can elect, by 31 January following the end of the tax year in which the benefit first arises, that the property remains in your estate for IHT purposes. Rental valuations of the property must be carried out every five years by an independent valuer.

You are exempt from POAT under the following circumstances:

• If you have an equity release scheme
• If your home has an annual rental value below £5,000 (for a sole occupant)
• or £10,000 (for a couple).

What is the CGT position, if I gift property to an adult child?

If you wish to gift property to an adult unmarried child via a trust, you can elect to hold over the CGT liability. Otherwise, CGT would be payable on such a transfer immediately because it is a gift of the property. However, no private residence relief will be available on a future sale.

How do I use trusts for IHT planning?

A financial adviser will often suggest using a trust to preserve family wealth. A trust is an obligation binding a person called a trustee to deal with ‘property’ (assets) in a particular way for the benefit of one or more ‘beneficiaries’.

Terms used when talking about trusts

Trust property can include money, investments, land or buildings and other assets.

The cash and investments held in the trust are called the ‘capital’ or ‘fund’ of the trust. This capital may produce income, such as interest or dividends. Land and buildings may produce rental income.

The ‘settlor’ is the person who creates the trust and puts property into it at the start or at a later date. The settlor states in the trust deed how the trust’s property and income should be used.

The trustees are the ‘legal owners’ of the trust property and must deal with it in the way set out in the trust deed.

‘Beneficiaries’ are the individual/s who benefit from the property held in the trust. These are usually named individuals or members of the settlor’s family.

Different beneficiaries can benefit from the trust in different ways, i.e. from the income only, the capital only, or both.

A trust might be created in the following circumstances:

• When someone is too young to handle their affairs
• When someone cannot handle their affairs because they are incapacitated
• To pass on money or property while you are still alive under the terms of a will
• When someone dies without leaving a will (intestate).

Different types of trust

When writing a will, there are several kinds of trust that can be used to help minimise IHT liability.

Bare trusts

A bare trust is one where the beneficiaries are named and cannot be changed. You can gift assets to a child via a bare trust, which will be treated as a PET until the child reaches age 18, and can then legally demand their share of the trust fund from the trustees.

All income arising within a bare trust in excess of £100 per annum will be treated as belonging to the parents (unless the gift was made by someone other than the parents). Providing the settlor survives seven years from the date of placing the assets in the trust, the assets pass IHT-free to the child at age 18.

Life interest or ‘interest-in-possession’ trusts

With these trusts, the beneficiary/ies (sometimes called the life tenant/s) have a legal right to all the trust’s income (after tax and expenses), but not to the property of the trust.

These trusts are typically used to leave income arising from a trust to a second surviving spouse for the rest of his or her life. On their death, the trust property reverts to other beneficiaries, (known as the remaindermen), who are typically the children from a first marriage

With a life interest trust, the trustees often have a ‘power of appointment’, which means they can appoint capital to the beneficiaries, (who can be from a widely defined class, such as the settlor’s extended family), when they see fit.

Transfers in

Transfers into interest-in-possession trusts are taxable as follows:

1. A 20% tax based on the amount gifted into the trust at the outset, which is in excess of the prevailing nil rate band;
2. 10 years after the trust was created, and on each subsequent 10 year anniversary, a periodic charge, currently 6%, applied to the portion of the trust assets, which is in excess of the prevailing nil rate band.

The value of the available ‘nil rate band’ on each 10 year anniversary will be reduced by the initial amount of any new gifts put into the trust within seven years of its creation.

Exit charges

There is an exit charge on any distribution of trust assets between each 10 year anniversary.

The charge is based on the following:

• The length of time between the distribution of assets and the most recent
• 10 year anniversary
• The value of the assets being distributed
• The effective rate of tax applied to the trust at the most recent 10 year anniversary.

If no tax was due at the most recent 10 year anniversary, then no tax will be due under the proportionate exit charge.

If the trust has business or agricultural property, then the IHT reliefs for these types of property can reduce or eliminate the IHT charges. Transitional rules apply to trusts established before 22 March 2006, so that in certain cases, for a new life tenant, the previous IHT treatment continues so that the trust funds are treated as belonging to the beneficiary/ies for IHT purposes.

Discretionary trusts

With a discretionary trust, the trustees decide how much income or capital, if any, to pay to each of the beneficiaries, although no beneficiary has an automatic right to either. The trust can have a widely defined class of beneficiaries; typically the settlor’s extended family.

Discretionary trusts are a useful way to pass on property while the settlor is still alive, allowing him or her to maintain some control over it through the terms of the trust deed. They are often used to gift assets to grandchildren, as the flexible nature of these trusts allows the settlor to wait and see how they turn out before making outright gifts. Discretionary trusts also allow for changes in circumstances, such as divorce, re-marriage and the arrival of children and step children after the establishment of the trust.

When any such trust is wound up, an exit charge is payable of up to 6% of the value of the remaining assets in the trust, subject to the reliefs for business and agricultural property.

Trusts for vulnerable persons

These are special trusts, often discretionary trusts, arranged for a beneficiary who is mentally or physically disabled. They do not suffer from the IHT rules applicable to standard discretionary trusts and can be used without affecting entitlement to state benefits. Strict rules apply, so professional advice is essential.

Whole of life assurance

If, despite all your planning, you believe there will still be an IHT liability on your death, you can buy a purchased life annuity (out of savings) and use the income to pay regular premiums towards a term, or whole of life, assurance policy. This is known as a ‘back-to-back’ arrangement.

Alternatively, you could simply pay the whole of life assurance premiums out of normal savings. These policies should be written in trust so that they fall outside your estate and the proceeds can be paid quickly to your beneficiaries when you die.

Spousal exemption

For spouses or civil partners dying after 21 March 1972 any unused inheritance relief may be passed to the surviving spouse to be attached to his or her relief subject to the surviving partner dying after 9 October 2007.

Prior to October 2007, without carefully drafted wills, a married couple, or civil partners, often failed to make full use of both IHT allowances to bequeath assets to children and other beneficiaries. This was usually because there were not enough assets in the estate to do so or because they were unaware of the facility to write ‘mirror wills’.

The spousal exemption means that a married couple or civil partners can bequeath up to £650,000 of assets to beneficiaries free of IHT during 2009-11, without having to do complex estate planning or write mirror wills.

FAQs on the spousal exemption

Do non-married couples benefit?

No, the spousal exemption only applies to legally married couples and registered civil partnerships. However, non married couples can still use their individual £325,000 allowances (2009-11) to bequeath assets to each other and their heirs, but only if they have sufficient assets to do so. The crucial difference is that a non married couple cannot transfer more than the prevailing individual IHT allowance to each other on first death, without it being subject to IHT.

My spouse died before 9 October 2007 and I haven’t remarried. Do I benefit from these changes?

Yes, the legislation is retrospective. However long ago your spouse died, you should be able to use both allowances based on the nil rate band prevailing in the year of the second death. There are special rules for deaths prior to 21 March 1972.

For example, if your spouse used only half of their allowance for the year in which he or she died (for example, only £45,000 of the £90,000 IHT allowance was used in 1987-88), the remaining 50% can be mopped up in the tax year of the second death and added to the survivor’s own exemption.

So if you were to die in tax year 2010-11, (the IHT threshold for married couples £650,000), a total of £487,500 could be bequeathed to your beneficiaries free of IHT. This is made up of (£325,000 (your own allowance) plus £162,500 (50% of £325,000 representing your deceased spouse’s unused allowance).

I already have a will trust in place to make use of both allowances. Should I change it?

This is probably a nil rate band discretionary trust, which was set up when you wrote your wills. If you and your spouse are both still alive, the trust will not have been created as these trusts only become effective on the death of the first spouse.

If the purpose of the trust was simply to use both spouses’ nil rate bands, it is of no great use now and it may be cheaper to redraft your will to remove the trust, as it will be incurring annual management fees to keep it running. Alternatively, your executors may be able to collapse it without the need to redraft your will.

My husband, who died some time ago, set up a discretionary will trust before his death. What are the implications for me and the other beneficiaries?

There is usually little you can do to alter the terms of such a trust, particularly if the beneficiaries are yourself and the children from a previous marriage. You could ask the trustees for advice, but the spousal exemption rules are unlikely to help in this case.