Tax planning - inheritance tax

A vital, yet sensitive, issue for many people to consider is inheritance tax (IHT), and forward planning is central to mitigating any issues around inheritance tax. 

Gifts out of surplus income

Normally, gifts from one individual to another are known as “Potentially Exempt Transfers”.  The value of the gift remains in a person’s estate for IHT purposes for seven years from the date of the gift.  After this point, the gift is excluded, provided that you cannot benefit from the asset which has been gifted.

However, a number of reliefs and exemptions can apply to IHT gifts. We have set out some of the most common below.

Firstly, individuals are entitled to an annual IHT exemption of £3,000. As we approach the end of the tax year you may wish to consider making gifts to make use of your annual IHT exemption of £3,000. You may also have a further £3,000 from the 2021/22 tax year if not already utilised.

There is an additional IHT exemption available where gifts are made out of surplus income; this exemption is not limited to a fixed amount and can be effective immediately, i.e. it is not subject to the seven year period it normally requires for gifts to become fully exempt. For this exemption to apply, the gifts need to form part of a regular pattern of giving and be fully funded from income remaining after payment of all normal expenses. This includes income tax liabilities and normal expenditure required to maintain your usual standard of living.

If gifting your surplus income is of interest to you, we can assist you in quantifying the surplus and what then may be given away, and also provide guidance on establishing a pattern of giving so that the relief may apply.

Finally, where an individual makes total gifts exceeding their Nil Rate Band (currently £325,000), then the IHT rate applied to the gift will gradually reduce if you survive more than three years but less than seven years after the gift has been made. This is known as “taper relief”.

Where an individual wishes to transfer value out of their estate but does not wish to pass substantial value to their children/grandchildren, they can consider the use of a trust.  Unlike gifts to individuals, a gift to a trust can trigger an immediate charge to IHT where the value transferred to the trust exceeds an individual’s available IHT Nil Rate Band.  Specialist tax advice should be taken prior to setting up a trust, as, while they are a very useful tax and wealth planning tool, they have a number of pitfalls and it is important that the structure is set up correctly.

There are a number of other reliefs and exemptions which can apply to specific assets or in specific circumstances.  If you would like to consider a wider review of your affairs to make best use of your IHT reliefs and exemptions, then please speak to your tax adviser.

Please note that gifting assets may result in Capital Gains Tax (CGT) liabilities. It is therefore important to consider whether you will trigger a capital gain by gifting an asset prior to making the gift. This will depend both on the nature and value of the asset being gifted.  

Insurance

Where gifts are made, the value of the gift remains in your estate for seven years after the gift is made. The value given away can be reduced by the exemptions or reliefs such as Agricultural Property Relief (APR) and/or Business Property Relief (BPR) where the asset qualifies for relief and is still used by the donee for a qualifying business activity and owned by the donee at the date of death (if you do not survive seven years from the date of the gift). However, many gifts do not qualify for relief or exemptions, and in these circumstances the gift will remain exposed to IHT for seven years.

Where there is a latent inheritance tax exposure on a gift, we often advise clients to protect their estates by taking out a suitable life insurance policy. This can simply be a policy for a number of years (perhaps to cover the remaining term of the seven years) to protect a lifetime gift. The cost of insurance will depend on your circumstances, but it can provide an efficient and cost effective solution. These policies are often used where a gift was made to which no relief applied (e.g. cash, residential property).

We also use insurance policies in the wider context to provide a degree of assurance that there will be some funds available to pay any inheritance tax liability. The policy is often based on joint lives, with the proceeds payable on the second death. This not only allows suitable tax planning to be taken after the first death, but also caters for a reduced amount of cover if that later becomes appropriate. However, where insurance is used to cover a gift for a seven year period, then a single life policy would be required.

Succession planning

For families passing on business assets to the next generation, the CGT and inheritance tax reliefs available can be generous. CGT gift "holdover relief" can allow trading assets, such as farmland and trading company shares, to pass on to the next generation with no immediate CGT charge. Non-business assets, such as let cottages, would not usually benefit from this relief. Where shares are transferred, the company’s balance sheet will determine the amount of CGT holdover relief available, and there may be a restriction on relief available.

On death, gifts made in the previous seven-year period are considered and relief from inheritance tax may continue to be available through Agricultural Property Relief (APR) and/or Business Property Relief (BPR) where the asset qualified for relief at the date of the gift, and is still used by the donee for a qualifying business. The rules here are different for assets and company shares, but the donee needs to either retain the asset that was transferred or use all of the proceeds to buy a suitable replacement asset for relief to continue. If the donee, for example, gifted part of their inheritance to their spouse, then this is likely to create some exposure for the original gift (and for the original donor).

Where assets pass on death, there is an uplift in value for CGT purposes. Consequently, if a sale by the next generation is being contemplated and there is a low base cost/March 1982 value, gift holdover relief may not be desirable where full IHT relief is available. This particular rule discourages lifetime gifts, and it has been suggested that this rule be removed. However, it remains the case that the CGT uplift on death remains for now, but it may be under threat when future changes are made.

Will planning

If you have not reviewed your Will in the last few years, it may now be an appropriate time to do so to ensure that it is up to date to meet your current personal and family circumstances.

You should ensure that the Will is drafted in such a way to ensure that you are able to qualify for and benefit from certain tax reliefs, such as:

• Residence nil rate band — worth up to £175,000 per individual; and
• 36% IHT rate if at least 10% of the net estate is left to charity.

Where you have assets that qualify for IHT reliefs such as Agricultural Property Relief (APR) and Business Property Relief (BPR) you should ensure that your Will is structured in a way which will capture the benefit of these reliefs. For example, where assets qualify for these reliefs in full, then it is often better for these assets not to be left to a surviving spouse - they may be left to children and/or a family trust. We can assist with reviewing your assets and identifying assets which may qualify for APR and/or BPR.

The effectiveness of any tax planning in this area depends upon individual circumstances and asset valuations in addition to how the legislation applies. Given the myriad of IHT reliefs and exemptions available, a detailed IHT review may be required to find the optimal solution for you.

Offshore bonds

Offshore bonds can often be overlooked when looking at estate planning. Offshore bonds offer a number of advantages that can help mitigate income tax and inheritance tax:

• The offshore bond offers tax-free roll up of income and gains — the tax point is deferred until the bond, or a segment of the bond, is surrendered.
• There is still an ability to take 5% withdrawals from the bond each year (this is a return of capital, but often described as "income" in marketing material) — this can provide 20+ years of tax-free "income".
• When gains are realised, there will be a chargeable event, subject to income tax. But this can be managed and timed carefully so that this gain is taxed in a chosen tax year.  It may also be possible to assign the policy to a spouse or child/grandchild to make use of their tax rates and bands. However, care must be taken as there are anti-avoidance rules in this area.
• Top slicing relief can reduce the amount of tax payable on a gain, particularly where the gain pushes the policyholder into higher rate tax for the year of surrender.
• Assigning the bond, or segments, can be done free of capital gains tax, and thus can provide tax planning opportunities, which encourages earlier gifting which may then have inheritance tax benefits.

Read the next section of our tax planning guide: Capital gains tax or return to the main page.