UK: Estate planning - Easy ways to reduce inheritance tax

Last Updated: 16 June 2005
Article by Emily Collins

Inheritance tax was previously seen as a tax on the very wealthy, but the rapid growth in house prices in recent years means that many more families are facing a potential tax charge on their inheritance.

The number of estates paying inheritance tax has risen by two-thirds over the past five years. According to a report by the National Audit Office, inheritance tax was paid by 30,000 estates during the 2003/04 tax year.

A recent report by Halifax found that 2.4 million properties exceed the 2004/05 inheritance tax threshold of £263,000. Therefore, it appears that the number of estates paying inheritance tax will continue to rise. The 2005 budget increased the threshold beyond statutory indexation to £275,000 for 2005/06, £285,000 for 2006/07 and £300,000 for 2007/08 in an attempt to make this tax fairer, but this is unlikely to make a significant difference.

The very wealthy can make use of the reliefs available to reduce inheritance tax by disposing of assets while maintaining their lifestyle. However, with the number of estates paying inheritance tax increasing, many people find they have assets in excess of the inheritance tax threshold, but do not have the level of wealth required to divorce themselves from their assets outright. Additionally, a large number of people are not comfortable making substantial gifts to their children absolutely, until they have achieved settled lifestyles.

There are a number of ways in which we can help individuals to structure their estates to ensure that any inheritance tax is minimised and that assets are passed on as desired.

General principles

Inheritance tax is charged on wealth at death, on certain lifetime gifts and on certain transfers into and out of trusts.

On death, the following basic principles are applied:

  • the first £275,000 of the estate is not taxed (tax year 2005/06);
  • the remainder of the estate is taxed at the rate of 40%, subject to exemptions and reliefs; and
  • assets passing between spouses are normally exempt from tax.

Exemptions and reliefs

Making gifts

The simplest way to avoid inheritance tax is to make gifts while you are still alive. Each tax year you can give away assets valued at £3,000 without a charge to tax. Any unused part of the exemption can be carried forward to the next tax year.

Small gifts of £250 to any one person per tax year are also exempt.

You can give £5,000 to your children as a wedding present. Grandparents can give £2,500 and any other person £1,000.

One of the few tax perks remaining associated with marriage is that gifts between husband and wife are normally exempt from inheritance tax. The same applies to gifts to charities and political parties.

Potentially Exempt Transfers

You can make other lifetime gifts, called ‘Potentially Exempt Transfers’ (PETs), without any charge to tax, as long as you survive for seven years after the gift. Even if you do not, there would be no tax to pay on PETs unless, when added to other transfers and the value of the death estate, they exceed the nil rate band.

Normal Expenditure out of Income

It is possible to make substantial gifts which are exempt from inheritance tax immediately, providing certain conditions are satisfied:

  • the gift is made as part of your normal expenditure;
  • the gift is made out of income, taking one year with another; and
  • you are left with sufficient income to maintain your normal standard of living.

Such gifts are deemed to be ‘Normal Expenditure out of Income’.

Business Property Relief/Agricultural Property Relief

Reliefs are available to reduce the potential inheritance tax charge on certain assets. For example, Business Property Relief (BPR) can reduce the inheritance tax on certain business interests and shares by up to 100%. This means that you can pass on family businesses free of inheritance tax. Similar reliefs exist for farms and agricultural property, known as Agricultural Property Relief (APR).

The family home

Planning relating to the family home has been a topical subject in the press of late, particularly since the introduction of legislation to prevent individuals gifting their home into trust but continuing to live in it free of an inheritance tax charge on death.

The options available to use the family home in planning have therefore decreased, but some opportunities remain, depending on individual circumstances.

Trusts and life insurance

One way to gift assets but to retain an element of control is to transfer the asset into a trust.

There are a number of different types of trusts and the provisions can generally be drafted to cover individual requirements. Certain trusts are very efficient for inheritance tax, as transfers in are treated as PETs on which no inheritance tax is payable providing the settlor lives for a further seven years. Life insurance policies can be used to cover the potential inheritance tax liability if PETs become chargeable should death occur within seven years of a gift or transfer into a trust.

If you do not feel comfortable in passing your wealth on at the current time, or if this is inappropriate due to the nature of the assets involved, life insurance can also be useful. By taking out a life assurance policy equal to the potential inheritance tax liability on your death, you can ensure that your beneficiaries are placed in funds to pay the tax bill. The cover needs to be structured carefully to ensure that it is payable when the tax becomes due, as this may be on a second death, where the majority of an estate passes first to a surviving spouse.

Tax-efficient wills

In our experience, many spouses have ‘backto- back’ wills leaving all their assets to each other. This means that £275,000 of assets are passed on to the next generation free of tax. However, there is a simple way of passing on assets of over £500,000 tax free.

This is achieved by both spouses drafting wills including a ‘Nil Rate Discretionary Trust Clause’. This means that, on the first death, £275,000 is paid into a trust which can be for the benefit of the other spouse. The effect of this is that the nil rate band is not wasted on the first death and this can save tax of £110,000 (£120,000 from 2007/08).

A married couple should also look to maximise the benefit of any APR and BPR available. Leaving such assets which qualify for these reliefs to the surviving spouse will waste the relief. Such property can be left (in addition to the nil rate band) to children or grandchildren, or put into a discretionary trust with the spouse as one of the beneficiaries.

Insurance-based solutions

A number of insurance companies offer plans that are structured to offer inheritance tax benefits to those whose wealth exceeds £275,000, but who cannot afford to make substantial outright gifts without taking steps to supplement their retirement income. These plans allow capital to be removed from the taxable estate, but for an ‘income’ to continue to be paid. The available plans have different structures and features and it is important that specialist advice is sought.

Qualifying investment portfolios

Certain quoted shares, including many of those listed on the Alternative Investment Market (‘AIM’), qualify for BPR. It is therefore possible to build up a diversified portfolio that is potentially able to enjoy 100% relief from inheritance tax.

AIM-listed shares are generally those of smaller, high growth companies and therefore great care needs to be taken to ensure that the inherent investment risk is suitable. Smaller companies require particular analytical skills and therefore engaging an appropriately qualified investment manager is a sensible step. ‘Due diligence’ to establish a manager’s credentials is also an important action before investments are made. To conclude, you can take a number of fairly simple steps to mitigate the inheritance tax payable. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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