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TAXGUIDE ICAEW KNOW-HOW

TAXguide 16/20: Basic inheritance tax planning

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Published: 17 Dec 2020 Update History

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“In this world nothing can be said to be certain, except death and taxes” – Benjamin Franklin

Inheritance tax neatly encompasses both of these certainties and although death cannot be avoided it is often possible to reduce the impact of the taxation. There is usually a point in everyone’s life when they realise they are mortal, whether that realisation is brought on by the death of a loved one or a global pandemic and hopefully they will turn to their trusted tax adviser for advice on the tax aspect.

Sue Moore provides guidance to assist non inheritance tax (IHT) specialist practitioners in giving some initial planning points to their clients. Steps can be taken to maximise the benefit of the residence nil rate band, business relief, agricultural property relief, and exemptions.

This TAXguide has been written by Sue Moore and edited by Philippa Vishnyakov.

Starting point

Where to start? The best place is to determine the size and composition of the estate. The simple pro forma that can be downloaded from this guide can help collate the value of the estate which will establish if there is an IHT problem or not. Some of the information may be available on the client file but it is likely that the value of investments and cash in ISAs is unknown as the information is not needed for annual tax returns. At the early stages a rough estimate of the value of land and buildings and personal chattels is all that is needed.

It is possible that an incumbent adviser will know the answers to many of the basic questions but one that is worth checking for a couple is that they are actually married or in a civil partnership (the writer has been surprised by a negative answer on more than one occasion!).

Other background information is required.

  1. How would the client like their estate to devolve if they are the first of the couple to die? And if they are the second to die?
  2. Do they have children, grandchildren? If so how many?
  3. Does the client anticipate receiving an inheritance in the next year or so?

Encourage your client to “die tidily”. They should leave a list of all their assets and who to contact for each to assist their executors.

General IHT rules

Transfers between spouses/civil partners

Inter-spousal/civil partner transfers in lifetime or on death are free of IHT. This exemption is retained on divorce up to the decree absolute.

Nil rate bands

On death the first £325,000 worth of assets can pass tax free – this is called the nil rate band (NRB). Subject to one or two exceptions such as business relief, the balance of the estate is charged to IHT at the rate of 40%. The NRB is renewable: if lifetime gifts are made using some or all of the nil rate band but are then survived by seven years, the nil rate band becomes available again as gifts more than seven years old are left out of account on death. If a gift is not survived by seven years it has first claim to the NRB on death, with the earliest such gift allocated the NRB first.

A new NRB was introduced from April 2017, the residence nil rate band (RNRB) which from 6 April 2020 is £175,000; it has increased from the initial £100,000 by £25,000 each year.

The RNRB is in addition to the £325,000 but is only available on death, and only on the death estate. It is reduced by £1 for every £2 that the estate value on death exceeds £2m. The £2m is measured without the benefit of reliefs such as business relief or agricultural property relief, and before exemptions.

In order to qualify for the relief the residence of the deceased has to be inherited by a direct descendant such as a child, although the definition is very wide. To qualify for the maximum relief the house has to have a net value of at least £175,000 or £350,000 if also using the RNRB from a previously deceased spouse/civil partner. It is possible to downsize to a property worth less than the available RNRB and still benefit from the RNRB based on the original property value provided the downsizing was on or after 8 July 2015.

Both of these nil rate bands can be passed to the surviving spouse to be used on their death to the extent they were unused on the first death.

A two-part article was published in TAXline in December 2016 and January 2017 which gives more detail of the RNRB and the downsizing provisions.

From April 2021 it is proposed to increase the NRB, the RNRB and the £2m threshold in line with the Consumer Prices Index.

Life insurance policy

An insurance policy payable on death can be paid outside of the estate and so will not be liable to IHT on death. Ideally the policy should be placed in trust from the outset to keep it outside the estate; it could be for the benefit of the beneficiaries under the will to enable them to pay the IHT due on death.

Depending on the level of the premium the payments will either be treated as regular gifts out of income or they will be treated as capital and to the extent they are within the annual gift allowance of £3,000 should have no impact on the overall IHT position.

A transfer into a trust is an immediately chargeable transfer which is why the policy should be written in trust at the outset when it has no value. If there is already a life policy in place it is certainly worth getting an estimate of its current value to establish if it is feasible to place the policy in trust without incurring a lifetime IHT charge but even so a transfer could use some of the NRB.

Pension

Pension funds of members who die before age 75 can pass to the member’s nominated beneficiaries free of all taxes including IHT. It may be necessary to contact the pension administrators to ensure that there are some nominated beneficiaries. It is possible to change the nominated beneficiaries.

If death is after age 75 the fund will still be free of IHT but it will be taxed on the beneficiaries as they draw it out at their marginal income tax rates whether they take it in a lump sum or piecemeal.

The pension funds need to be designated to the chosen beneficiaries, not necessarily drawn, within two years of death (or two years of the pension administrators being notified of the death).

Given the favourable IHT treatment of pension funds, where possible, other savings should be used in preference to drawing the pension.

Key reliefs

Business relief 

Business relief (BR) can give relief of up to 100% of the value of business assets. Business assets include sole trades, partnerships and shares in private trading companies but not investment companies.

There have been several cases where HMRC has challenged a claim to business relief, frequently for holiday lets. A recent case (Cox (Executors) v HMRC [2020] UKFTT 442 (TC)) regarding Scottish holiday apartments was decided for HMRC with the judge concluding, “that the Crail House letting business falls firmly on the investment side of the line” and that, “the business operated by Sheriff Cox consists “mainly of…making or holding of investments” for the purposes of s105(3) IHTA [Inheritance Tax Act 1984]”. Although additional services were provided they were not deemed sufficient to raise the status above the threshold to make it a trade rather than an investment.

On the other hand the Vigne case found for the taxpayer; this was not a holiday let but a stable yard and 30 acres of land used for a livery business. The business provided services over and above those normally provided for a grass livery or a DIY livery and it was these additional services that swung the decision in favour of the taxpayer.

It is always worth looking to see if additional services can be provided where an asset such as a holiday let, caravan park or any land and/or building asset generating income is owned. The principles established in the Farmer case (Farmer v IRC [1999] STC (SCD) 321) to look at the business in the round still hold good.

The Special Commissioner, Dr Brice, summed up her approach by saying:

“Applying the principles derived from the authorities to the facts of the present appeal the following factors can be identified as relevant to a decision of what the business consists of, namely: the overall context of the business; the capital employed; the time spent by the employees; the turnover; and the profit. When these factors have been considered it will then be necessary to stand back and consider in the round whether the business consisted mainly of making or holding investments.”

The threshold to cross to qualify for business relief is that the business is wholly or mainly trading, so in excess of 50% trading. Once that barrier is crossed it is necessary to look and see if there are any excepted assets in the business. An excepted asset is one that is not used for the business, note that the test is “used for the business” not “used for the trade” so for example a factory unit surplus to the needs of the trade and rented out is not an excepted asset as it is used for a rental business. Cash could be an excepted asset but if it is being held for a purpose, for example to buy a new factory when one becomes available then it is not an excepted asset.

Excepted assets do not qualify for business relief so relief will be less than 100% of the total value of the business asset if there are some excepted assets.

Most companies on the Alternative Investment Market (AIM) qualify for BR so it may be appropriate to include AIM shares in a stocks and shares portfolio. The AIM market is the baby sister of the main stock market, the companies listed there tend to be smaller and they are more risky but there are brokers who specialise in putting together a well balanced portfolio of AIM shares that have a reasonable risk level and pay dividends.

Assets must have been held for at least two years for BR to apply. A binding contract for sale at the point of transfer, death or gift, will prevent a claim for BR as the business asset is about to become cash. It is important to ensure that shareholder agreements do not create a binding contract for sale on the death of a shareholder.

Agricultural property relief

Agricultural property relief (APR) is of more limited use than BR. It applies to assets including agricultural land, pasture, buildings used for intensive livestock or fish rearing where occupied with agricultural land or pasture, farm cottages and their land of a character appropriate, farm buildings and their land of a character appropriate, farmhouses and their land of a character appropriate, stud farms and land in habitat schemes. The asset must be in the UK, the Channel Islands, the Isle of Man or an EEA state. The relief only covers the agricultural value of the asset: this is often less than the market value even when there is no hope/development value, and this extra value would not have relief.

It is often necessary to combine APR and BR to obtain the maximum relief available.

There have been several tax cases relating to claims for APR on a farmhouse. In order to qualify for APR there must be a farming business and the business must be run from the house but also the house must be of character appropriate. A lifestyle farmer with a large grand house and very little land is unlikely to qualify for APR.

To qualify for relief the land must have been farmed by the owner for a period of two years up to the date of transfer or owned for a period of seven years during which it was occupied for the purpose of agriculture. If the owner is the farmer or it is leased or let by the owner on a tenancy since 1 September 1995, the APR is 100% otherwise it is 50%.

As with BR a binding contract for sale at the point of transfer, death or gift, will prevent a claim for APR.

Lifetime planning

Gifts to individuals are potentially exempt transfers (PETs). No IHT is chargeable on the transfer if the transferor (person making the gift) survives seven years after making the gift.

If the transferor survives between three and seven years from the date of the gift, this reduces the rates of IHT payable. A gift made within three years of death will attract IHT at the full rate of 40%. For these taper rules to have any impact the gift must be for a sum in excess of the nil rate band as it is not the size of the gift that is tapered but the tax rate. Lifetime gifts below the nil rate band are charged at 0% if they come into charge on death within seven years and so the charge cannot be tapered.

Although making gifts sooner, rather than later, is preferable to ensure the seven-year survivorship, care must be taken that the gift does not give rise to a capital gains tax (CGT) liability. A gift of an asset likely to increase in value, for example a plot of land that may be approved for development in the future, can be very tax efficient. Even if the gift comes into charge because it is not survived by seven years, it is the value at the time of the gift that is taxable, not the current value.

When lifetime gifts come into charge to IHT on the death of the donor, it is the recipient of the gift that is liable for the IHT. It is possible to include a clause in the will to say that all IHT arising as a result of death should be paid by the estate otherwise the recipients of the gifts should be advised to ensure they have funds to pay any potential tax, either reserving it from the gift or taking out an insurance policy on the donor’s life for seven years.

Gifts to grandchildren are tax efficient as the capital skips a generation for IHT purposes and any income arising from the asset gifted is taxed on the child not on the parent (income arising on gifts from a parent to a minor child are taxed on the parent).

There are various financial products available on the market that may help to reduce IHT liability whilst still retaining some benefit from the asset, (eg, Discounted Gift Trusts) and a financial adviser could advise on these if required. 

It is important not to gift so much that the standard of living of the donor falls to an unacceptable level. The tax tail should not be allowed to wag the dog!

Other exemptions and reliefs to be considered are as below.

Use of annual exemption

  • This is currently £3,000 per year per person.
  • Any unused amount in one year can be carried forward to the next year only.
  • Current year allowance must be used in priority to any brought forward amount.

Small gifts

Gifts of up to £250 can be given to an individual each year but if the £250 is exceeded it is not just the excess that eats into the annual exemption but the full amount of the gift. This exemption was intended to cover birthday and Christmas presents but as it has not increased for many years it arguably is now inadequate.

Gifts in consideration of marriage

Gifts in consideration of marriage of up to the amount shown may be made to the bride and/or groom by the following:

 

£

Parents

5,000

Grandparents

2,500

Groom or bride

2,500

Other person

1,000

The Office of Tax Simplification looked at IHT in 2018 to 2019. In its second report published in July 2019 one of the proposals was that this and the annual exemption should be combined into one overall personal gift allowance.

Normal expenditure out of income

This can be a very useful exemption where it can be established that the gift is part of a pattern of giving. This can be achieved if:                                 

  • the payments are typical and habitual, or at least have the intention to be so;
  • the payments are out of net spendable income; and
  • the “giver’s” usual standard of living is not adversely affected.

Life insurance premiums can often fall into this category.

It is advisable to have a letter in place setting out the intention to make regular gifts out of surplus income and to keep a record of the annual income and approximate annual expenditure. These records will help the executors as the exemption will only be tested on death. The gifts do not need to be made every year as they are out of surplus income and in some years there may not be surplus income.

Nil rate band - tax free threshold

As noted above the nil rate band (NRB) is the first slice of the chargeable transfer on either life or death and is charged at 0%.

  • Since 6 April 2009 the threshold has been £325,000.
  • It is available for lifetime transfers and those made on death.
  • The threshold can be renewed every seven years during an individual’s life as PETs drop out.
  • Any unused part of a nil rate band can be transferred to a surviving spouse/civil partner and used on their death.

Resistance nil rate band

As noted above, the residence nil rate band (RNRB) is available to set against the value of a residence used by the deceased and bequeathed to descendants. It can only be used on death. The RNRB is £175,000 for 2020/21 and is due to rise by inflation from April 2021. As with the NRB any unused portion of the RNRB can be transferred from the first spouse to die and used on the second death.

It is the net value of the residence after deducting any outstanding mortgage that qualifies for the RNRB. If the mortgage reduces the value of the home below the available RNRB is it possible to pay off the mortgage? If there is more than one property that could qualify for the RNRB, it does not have to be the main residence simply one that has been lived in at some time and is in the estate on death. If there is more than one property that could qualify for the RNRB could any mortgages be rearranged such that one of the properties is debt free and above the value of the available RNRB?

The RNRB can be restricted, for example if the net value of the residence is below the available value of the band and also if the total value of the estate exceeds £2m before reliefs such as business relief. If the estate does exceed £2m the RNRB is reduced by £1 for every £2 of excess. 

Lifetime planning to reduce the estate below £2m can save tax of £140,000 on a second death. Equalising estates between married couples/civil partners such that neither estate is over £2m can save tax if half the house is gifted to direct descendants on the first death. Either the balance of the estate of the first to die can be left such that it is not included in the estate of the surviving spouse, although this would give rise to a tax charge on the first death if the estate was over £500,000, or left to the surviving spouse with the intention of carrying out further lifetime planning to reduce the estate value of the survivor below £2m.

Lifetime gifts coming into charge on death are not counted in the value of the estate for the purposes of determining the £2m so a deathbed gift could take the estate below £2m. However, a gift of cash, say, would be more appropriate than an asset with a potential gain; care would need to be taken to ensure that an unnecessary CGT charge does not arise.

On the other hand reliefs that reduce the chargeable estate are not deducted for the purpose of calculating the estate value for RNRB, so the usually beneficial holdings of business and agricultural property offer no advantage in this respect.

Charitable and political party gifts

Gifts to most UK charities and some overseas charities are exempt from IHT as are gifts to registered community amateur sports clubs.

Gifts to UK political parties are exempt from IHT provided at least two members of parliament (MPs) were returned to the House of Commons on the last general election or one MP was returned and candidates of that party received at least 150,000 votes.

Reservation of benefit

For a gift to be effective the donor must not retain any benefit from the gifted asset, otherwise it would still be included within the estate on death. This could cause additional tax to be payable; IHT would be charged on the value at the date of death if higher rather than the date of the gift. The tax-free uplift to market value would be lost.

Gifts not caught by the reservation of benefit provisions can be caught by the pre-owned asset tax (POAT) charge, an income tax charge introduced to prevent IHT avoidance.

Double tax charge

A lifetime gift of a chargeable asset could give rise to a CGT charge at the time of the gift which, although the rate of CGT is less than IHT, is not an ideal solution.

On death there is a CGT-free uplift to market value and it is the market value that is liable to IHT; if CGT were charged as well as IHT it would be double taxation.

The worst-case scenario would be to make a lifetime gift, pay the CGT and not survive the gift such that it became liable to IHT on death.

Anticipated inheritance

If an inheritance is anticipated it should be considered as to whether it is needed/wanted or if it would just add to an existing IHT problem. If it is not wanted then either the prospective testator could be consulted and asked to change their will to divert the inheritance to a different beneficiary, or after the death of the testator a deed of variation could be used within two years of the death to divert the inheritance elsewhere.

Deathbed planning

If it known with reasonable certainty that one of a couple will be first to die, for example they have cancer and are on end of life care it may be possible to do some deathbed planning. Assets held by the surviving partner standing at a gain can be transferred to the dying partner to obtain a tax-free uplift to market value on death. It is essential to ensure the assets transfer back to the survivor by the will. Similarly assets standing at a loss held by the dying partner can be gifted to the surviving spouse to preserve the loss.

As previously noted, a gift on the deathbed can reduce the estate below the £2m mark to qualify for the RNRB in full but if the gift is of a chargeable asset this could give rise to a CGT charge.

If the value of the estate is taken over the £2m threshold by property that qualifies for a relief such as BR consider gifting the property into a trust before death, holding over the gain, but beware the loss of the tax-free uplift to market value. This may not be of any consequence if it is a family business that there is no intention of selling.

Will planning

Executors

Choose the executors of the will carefully; it is often a good idea to include the surviving spouse as an executor. Adult children can also be included as executors. There is no requirement to include a professional executor.

In commorientes

A survivorship clause of say 30 or 60 days is normally included in a will. This avoids the additional administrative burden of administering the estate of the first spouse to die (passing the estate to the surviving spouse) only to have to then administer the combined estates when the second death is soon after. However, the law of commorientes in England and Wales says that in the event of simultaneous deaths the elder dies first. The interaction of the law of property and IHT legislation means that in the event that a married couple/civil partnership die simultaneously, such that it is not possible to determine who died first, the estate of the elder can pass completely free of IHT provided the survivorship clause is excluded.

By excluding the survivorship clause in the event of simultaneous death in reality the estate of the elder will pass under the terms of their will as if their partner had predeceased them following property law and so for example will pass direct to the children. However for IHT purposes it will pass under the terms of the will to the younger partner and thus free of IHT. Survivorship clauses should be included in both wills where a married couple/civil partnership leave their estates to the survivor but in the will of the elder the survivorship clause should be excluded in the event of simultaneous death.

Charitable gifts

Gifts to charity are exempt from IHT and if at least 10% of the estate is gifted to charity the tax is charged at 36% on the chargeable estate rather than at 40%.

Tax on lifetime gifts

Where lifetime gifts have been made, it may be desired to have any tax becoming payable as a result of the death of the donor to be paid from the estate, in which case a clause should be included to this effect.

Guardians for minor children

If there are minor children it is a good idea to name guardians. These will be the financial guardians not necessarily the person who cares for the children following the death of the parent. Naming the guardians does not make it legally binding.

Foreign assets

It is usually simpler to have a will for each country where assets are owned; it makes it easier to administer a foreign estate with a will in the appropriate country. Each will should make it clear that it is only dealing with assets in that country.

Long stop

Ideally there should be a long stop in the wills in the event an entire family die together; this could be more distanced family members or charities or a combination.

Use of trusts

Trusts are a subject to themselves and have not been mentioned to any real extent in this basic guide but they can be used in both lifetime and will planning.

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