19 February 2018

Spotlight on Inheritance Tax

As we approach the end of another tax year, we thought it might be helpful to provide some useful tips in relation to inheritance tax.

Often described as a voluntary tax, this is one that can be painful to discuss within families, and which often results in a surprise tax bill at the least welcome time.  Here are some areas to consider to reduce the potential exposure to inheritance tax.

Annual exemption

Every individual has an annual inheritance tax exemption, which has stood at £3,000 for many years.  This means that gifts up to that level can be given without any inheritance tax consequences.  If the annual exemption from one year is not used, it can be carried forward but only as far as the next tax year, allowing gifts of up to £6,000 in that year to be made IHT free.

Small gifts exemption

This can be extremely useful to enable gifts to be made to individuals of no more than £250 per person.  There is no limit on the number of gifts that may be made by one person to another, provided each gift is no more than £250 per annum.  This might allow gifts to be made by grandparents at Christmas time and for birthdays without any inheritance tax affects.

Gifts in consideration of marriage

This inheritance tax exemption is often overlooked but can be very useful in providing some monetary assistance to the future couple.  Up to £5,000 by a parent of either party to the marriage can be gifted, with limits of £2,500 by one party of the marriage to the other party or by a grandparent or remoter ancestor, and £1,000 in any other case. 

Normal expenditure out of income

This has proved to be a very useful exemption for individuals who live well within their income levels.  Regular gifts can be made of surplus income, and these will be immediately outside the inheritance tax net, provided it can be demonstrated that they have been made out of surplus income.  This can be demonstrated by looking at the net of tax position for the individual and their usual outgoings, and calculating the surplus.  These gifts are preferably made in cash, and it should be shown that these are habitual.

These exemptions are useful, but with the exception of the last one, they are unlikely to be able to take large amounts out of an individual’s Estate very quickly.  To do that, we need to look at some of the other routes available.

Chargeable transfers

Any transfer which isn’t a potentially exempt transfer or covered by one of the available inheritance tax exemptions is going to be a chargeable transfer.  This is now largely restricted to transfers into trust of assets that don’t qualify for business property relief or agricultural property relief.  To the extent that the nil rate band is available, currently £325,000, assets up to this value are chargeable to tax at 0%, with any transfer of value over and above that level being charged to tax at 20%.  At the point of death, the Executors must look back 7 years to see what gifts have been made. If these gifts were chargeable to inheritance tax at the time they were made, there is a further tax charge at 20% at the time of death.  If the 7th anniversary of the gift passes, a fresh nil rate band arises, giving another opportunity to gift assets up to that value without incurring a charge to tax.

Potentially Exempt Transfers (PETs)

I’ve mentioned 7 years when considering chargeable transfers, and many people are aware of the “7 year clock” but what exactly does that mean?  Well, any gift that is not immediately chargeable to inheritance tax or covered by one of a number of inheritance tax exemptions is regarded as being a PET.  This means that it is treated as being exempt at the time of the gift, however if the donor dies within 7 years, the PET fails and is brought into the tax net.  This might result in some of the nil rate band (currently £325,000) being used to cover the PET, leaving less to use against the assets in the Estate.  This might not be drastic if the assets are passing to a surviving spouse, in which case they will be exempt from inheritance tax.  However, it may mean that some of the nil rate band needs to be used on the first death in order to cover the failed PET.  This will reduce the level of the unused nil rate band, so that a smaller amount can be claimed against the combined Estate on the death of the surviving spouse.  If the nil rate band is wholly unused on the first death, this currently means that assets of up to £650,000 can be exempt from inheritance tax on the second death.  Alternatively, if the PET is particularly large, it may use up the whole of the nil rate band, and give rise to a tax charge at 40%.  A form of taper relief is available in respect of the tax charged on a failed PET, which means that the longer an individual survives following a gift, the less tax will be paid. 

Spouse exemption

Many couples will have “mirror image” Wills, so that on the death of either of them, the assets will pass to the survivor.  The whole of the Estate can therefore pass to the surviving spouse free of inheritance tax.  Not only that, but assets transfer at market value at the date of death, without incurring any capital gains tax.  This can be an extremely useful planning tool, as it then allows the surviving spouse to potentially gift these onto the next generation without being liable for capital gains tax.  For example, shares which are worth £50,000 have an inherent gain of £10,000 when the wife dies.  These are transferred to her surviving husband at their market value of £50,000 and the gain of £10,000 is wiped out.  This would then allow the husband to potentially pass these onto the next generation with either no gain or a much smaller gain, as his base cost would become the market value.

Everyone takes a very different approach towards inheritance tax, but hopefully this demonstrates that there are relatively simple steps that can be taken to reduce the family’s exposure to this tax.  “Little and often” can be very effective for many Estates, whereas some will need a more structured approach to reduce their potential tax liability to something more manageable.  The key to good inheritance tax planning is communication amongst all the interested parties.  As Benjamin Franklin said “In this world nothing can be said to be certain, except death and taxes” and whilst death is certainly a subject that people prefer not to talk about, in this case if it can reduce the exposure to taxes, it may be a conversation worth having.

Bookmark and Share