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The importance of Inheritance Tax planning

Technical article

Publication date:

08 April 2021

Last updated:

21 April 2021

Author(s):

Personal Finance Society

In this article, we provide a general overview of some of the inheritance tax (IHT) planning opportunities currently available.

 

In this article, we provide a general overview of some of the inheritance tax (IHT) planning opportunities currently available. Of course, in practice, each client’s objectives and circumstances will need to be borne in mind as forming the basis of any advice which is given.

Since 2009/10 the nil rate band has been capped at £325,000 and it was expected to remain at this level until 2020/21; but in the recent Spring Budget, it was announced that it will be capped at this level until 2025/2026 – all in all a total of 17 years!

Previously it was generally the case that the nil rate band increased on an annual basis. In the few years leading up to the 2009/10 tax year the nil rate band thresholds were as follows:

  • 2005/2006 - £275,000
  • 2006/2007 - £285,000
  • 2007/2008 - £300,000
  • 2008/2009 - £312,000
  • 2009/2010 - £325,000

Given the historic increase in the nil rate band, if the threshold had increased in line with inflation and assuming 2.5% inflation each year by the end of the 17 year ‘freeze’ the nil rate band would be expected to be around £494,525 – a difference of £169,525 which could potentially have resulted in an IHT saving of £67,810 for an individual.

Further, if someone had used the nil rate band on first death, for example, via a discretionary will trust, and the trustees had invested £325,000, assuming a growth rate of 4% those investments could have increased in value to around £633,067. This in turn would have saved 40% IHT on the growth of £308,067 had the assets passed directly to the survivor on the first death. It should be remembered that assets held within a discretionary trust will be subject to the usual reporting requirements as well as potential exit and periodic charges.

In addition, in April 2017 we saw the introduction of a residence nil rate band which may help to ease the IHT burden for those who can meet the relevant conditions, although in many cases advice will still be required to ensure wills are drafted properly to make use of the residence nil rate band. It is also important to note that the current residence nil rate band of £175,000 is also frozen until 2025/2026.

It is clear that as a result of the ‘frozen’ nil rate band and residence nil rate band, more and more individuals have been brought into the IHT net in recent years.

With this in mind IHT planning has become increasingly important for many individuals and is likely to remain so over the course of the next few years. Undoubtedly the planning that individuals can carry out will, of course, depend to a large extent on the nature of the assets they own, although it is still advisable for clients to seek advice to take maximum advantage of some of the IHT planning opportunities which are available to them.

 

Use IHT exemptions

The starting point for anyone who is wishing to carry out IHT planning is to use their exemptions, the most common ones being:

  • Annual exemption – each individual can give away £3,000 each year and make use of the previous year’s exemption if not already used provided the whole of the current year’s exemption is used first.
  • Small gifts exemption – up to £250 can be given to any number of individuals (note this exemption cannot be combined with any other exemption in favour of the same individual).
  • Normal expenditure out of income – gifts can be made out of surplus income provided the gift does not affect the donor’s usual standard of living and is made on a regular basis.

Planning in this area is often overlooked with few clients using these exemptions to their full potential – even though over time regular use of these exemptions can result in significant IHT savings. Take the example of someone who has made use of their annual exemption over, say, 20 years – £60,000 would have been gifted free of IHT, saving £24,000 in tax!

Individuals can also consider investing in assets which qualify for business relief where this is in line with their risk profile. For example, under current legislation provided shares have been held for at least two years and the shares are in a qualifying unquoted trading company they will attract 100% business relief and thus save 40% IHT on death.

 

Lifetime planning

For some individuals it may be possible to make other lifetime gifts, whether outright to another individual or by executing a trust.

The current regime for outright gifts (including gifts to bare trusts) is favourable, thereby providing scope for lifetime planning. Outright gifts are ‘potentially exempt transfers’ (PETs) for IHT, meaning that no lifetime tax is payable on the gifted amount, or on any increase in value if the donor survives for the required seven-year period after which the gift is free of IHT. Also, there is no restriction on the nature of such gifts or on the amounts which can be gifted. So, provided the donor is in reasonable health and is happy to make such gifts, substantial IHT savings can be made.

In cases where an outright gift is not a suitable option a trust (other than a bare trust) can be used. Today most forms of trusts where the client wishes to maintain control of the assets are taxed as relevant property trusts and so are subject to the IHT discretionary trust tax regime. Because the trust fund does not vest in anyone’s estate for IHT purposes, associated IHT charges apply on creation, when capital is appointed out of the trust and on each ten-year anniversary. These are more commonly known as entry, exit and periodic charges. In some cases reporting obligations may also need to be fulfilled.

There are also a number of other types of trusts which are widely available for IHT planning purposes which can be used where the client can retain access to the trust assets if they need to, for example a gift and loan trust, a loan trust and a discounted gift and income trust. Advice should be sought to determine which (if any) of these trust options are likely to be suitable.

 

Deeds of variation

Where assets are inherited, whether under a will or under the intestacy rules, it is possible to redirect the inheritance to achieve an immediate IHT saving by using a deed of variation.

Ordinarily, the inherited assets will accumulate in the taxable estate of the receiving beneficiary who may not want or need the inheritance. Instead of choosing to make a gift of the inheritance (which would either be treated as a potentially exempt transfer or a chargeable lifetime transfer), it is possible for someone to take advantage of the deed of variation option and achieve an immediate IHT saving on their own estate.

To achieve the desired outcome, the variation must:

  • be in writing;
  • contain a statement that the relevant legislation (s142 IHTA 1984) is intended to apply;
  • be made within 2 years of death by the person(s) who would have benefited from the original gift;
  • the property must have been included in the deceased’s estate at the date of death; and
  • the variation must not be for consideration.

In practice, there is no requirement to vary the destination of the entire amount of the inheritance enabling the client to choose to vary only part of it. It is possible to direct an amount directly to an individual or to a trust. The option chosen will of course depend on the client’s specific circumstances taking account of factors such as whether they are wealthy in their own right, whether they are likely to want to retain control and whether they may wish to benefit in future should the need arise.

A variation into a discretionary trust enables the client to retain access by being named as a beneficiary. They can also maintain control by acting as one of the trustees. This is a viable planning option which does not fall foul of the gift with reservation provisions or pre-owned assets tax – the variation is effectively treated as having been made by the deceased for IHT purposes provided the necessary conditions are satisfied.

Note that in cases where the variation is into trust and the client is included as a beneficiary, they will be assessable to tax on any income arising within the trust under the settlor-interested trust provisions.

 

Insure against the liability

Many individuals, especially those whose wealth is mainly tied up in property, may choose to insure against the potential IHT liability. This can be achieved by taking out a whole of life policy in trust. Provided the premiums are covered by the annual exemption or the normal expenditure out of income exemption there would be no transfer of value for IHT on payment of those premiums. As the policy is held in trust, no probate should be required on death of the life/lives assured. This means that there would then be available funds free of IHT to meet the tax liability on death.

 

Wills

Finally, it is vital for clients to review their will on a regular basis and ensure it is drafted in a way which meets their chosen objectives as well as maximising tax savings.

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This document is believed to be accurate but is not intended as a basis of knowledge upon which advice can be given. Neither the author (personal or corporate), the CII group, local institute or Society, or any of the officers or employees of those organisations accept any responsibility for any loss occasioned to any person acting or refraining from action as a result of the data or opinions included in this material. Opinions expressed are those of the author or authors and not necessarily those of the CII group, local institutes, or Societies.

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