Inheritance Tax Planning
Updated January 2018
This Briefing Note provides an overview of some of the key issues related to inheritance tax planning. It is intended only as general guidance and should not be relied upon as legal advice. If you have any queries concerning your personal situation, please contact us for advice on your specific circumstances.
What is inheritance tax (IHT)?
Inheritance tax (IHT) legislation is set out in the Inheritance Tax Act 1984. IHT is primarily a tax paid on assets upon someone’s death. These can include:
- Funds in bank accounts.
- Money paid out through life insurance policies.
- Businesses owned by the deceased.
- Assets held in ‘life interest’ trusts.
IHT can also arise from other transactions, including:
- Gifts to individuals.
- Gifts to certain types of trust.
- Gifts to companies.
- Gifts made by close companies (broadly speaking, private companies owned and controlled by fewer than six individuals).
- Trust reorganisations and terminations.
Does IHT apply to overseas assets?
A person domiciled in the UK is subject to IHT on assets held elsewhere in the world as well as those situated in the UK.
Do those not domiciled in the UK pay IHT on UK assets?
Those not domiciled in the UK who have UK assets are subject to IHT on their UK estate only.
NB: In the context of IHT, ‘domiciled’ has a specific legal meaning. A person can be a UK resident for many years but be domiciled elsewhere. In rarer cases, a person can be considered domiciled in the UK for IHT purposes without having visited the country or apparently having strong connections here.
The nil-rate band
An IHT rate of 0% applies to the first £325,000 of an estate, meaning no IHT is payable on that element. This portion of the estate is called the nil-rate band. Above this £325,000 threshold the estate will owe tax at 40% (or 36% if the person leaves at least 10% of their net estate to charity). As referenced below, the nil-rate band can be reduced or exhausted by gifts made within seven years of death.
The 2017/18 tax year saw the introduction of an additional residence nil rate band (RNRB) allowance if the deceased leaves their interest in the family home to direct descendants (such as children, step-children and/or grandchildren). This only applies to their main home, but can be available even if that home has been sold after July 2016.
The RNRB is being phased in gradually. For the 2017/18 tax year the maximum additional allowance is £100,000, boosting an individual’s total IHT allowance to £425,000 (£850,000 for a married couple). The maximum allowance will rise by £25,000 each tax year until it reaches £175,000 in 2020. This will give an individual to whom the RNRB applies a potential total IHT allowance of £500,000 or £1 million for a married couple. For estates worth more than £2 million the tax relief is tapered away.
Beyond the 2020/21 tax year, the maximum RNRB allowance will rise in line with inflation based on the consumer price index.
Passing your IHT allowance to your surviving spouse
In most cases any unused portion of the nil-rate band and RNRB can be transferred to a surviving spouse or civil partner after a person’s death. Thus the person’s spouse or civil partner effectively inherits the unused percentage of the nil-rate band and RNRB – although the transfer is not automatic. It must be claimed within two years of the second death occurring and it is therefore important that detailed records pertaining to the estate of the first spouse should be retained.
Exemptions from IHT
Gifts to certain people or bodies are exempt from IHT and do not affect the nil-rate band. These are:
- Gifts to a spouse or civil partner. This exemption applies provided both parties are domiciled in the UK for IHT purposes. Where one party is not UK domiciled, there is an upper limit to the exemption.
- Gifts to charities. Outright gifts to UK, EU, Norwegian, Icelandic and Liechtenstein charities (or charitable trusts from which only these charities can benefit) are exempt.
- Gifts to UK political parties. To qualify, at the last general election, at least two party members must have been elected to the House of Commons or one member elected and at least 150,000 votes given to candidates who were members of the party.
- Gifts of land to housing associations or registered social landlords.
- Gifts for national purposes. There is a list of bodies and institutions covered by this exemption. They include any national institution that exists wholly or mainly for the purpose of preserving a collection of scientific, historic or artistic interest for the public benefit, and any library whose main function is to serve the needs of teaching and research at a UK university.
- Gifts to heritage maintenance funds. These are trusts that maintain historic buildings or land of scenic, scientific or historic interest. The trust will not incur any ongoing IHT charges as long as it meets certain conditions.
- Transfers to employee trusts. A shares transfer from an individual to an employee benefit trust (EBT) is exempt provided it meets certain conditions.
In addition, people in certain dangerous roles are exempt from IHT if they die in active service. This includes those in the armed forces, police, fire brigade and ambulance service. The exemption also applies if the person is injured on active service and their death is hastened by the injury.
Exemptions for lifetime gifts only
There are additional exemptions for lifetime gifts if none of the above exemptions apply. These include:
- Gifts that form part of the person’s normal expenditure out of after-tax income, as long as this leaves the person with sufficient income to maintain their usual standard of living. There must be a regular pattern of giving, for example, paying annual school fees for a child or paying the annual premium on a life policy for someone else’s benefit. The first gift in a series can qualify if it can be proved further gifts were intended.
- Small gifts to any one person. Gifts of up to £250 per tax year to any one person are exempt. However, if the £250 limit for any one person within a single tax year is exceeded, then no portion of the gifts to that person will be exempt.
- Wedding and civil partnership gifts. Gifts up to a certain limit are exempt: each parent can give up to £5,000, each grandparent (or remoter ancestor) up to £2,500 and any other person up to £1,000. The gifts can be made to either or both parties of the marriage or civil partnership. In addition, either of the couple can gift the other up to £2,500. The gift must occur on or before the ceremony and must be conditional on the ceremony taking place. The exemption does not apply if the ceremony does not take place.
- Annual exemption. Lifetime gifts that do not qualify for any of the other exemptions are exempt up to £3,000 a year. Any unused portion of the annual exemption for a particular tax year can be carried forward to the next tax year only.
Potentially exempt transfers (PETs)
IHT may be payable as a result of outright gifts made within the seven years preceding someone’s death. These types of gift are called potentially exempt transfers (PETs), and the seven-year period is intended mainly to prevent people avoiding IHT by giving away assets shortly before they die.
As well as outright gifts, PETs can include the sale of assets for less than their full market value to certain family members, rent-free use of property and fixed-term interest-free loans. There are, however, certain types of ‘excluded property’ that fall outside the scope of the legislation.
If no other exemptions are available, a gift may fall out of IHT charge with the passage of time. PETs are so called because if the person who made the gift (the donor) survives for seven years from the date of the gift, the gift becomes exempt.
If the donor dies within seven years of making the gift, the gift becomes chargeable and will count against the donor’s nil-rate band. However for substantial gifts (with a total value higher than the nil rate band) the longer the donor survives after making the gift, the lower the IHT. This incremental reduction in IHT is called taper relief and is calculated as follows:
- 0-3 years: 0%
- 3-4 years: 20%
- 4-5 years: 40%
- 5-6 years: 60%
- 6-7 years: 80%
- 7 years or more: 100%
NB: Taper relief is applied to the IHT due, not to the value of the gift. Therefore the full value of the gift still counts against the person’s nil-rate band allowance if seven years have not elapsed since the date of the gift. If the total amounts gifted are lower than the nil-rate band it follows that there is no taper relief available.
Reduction for gifts to charity
Those who die on or after 6 April 2012 and leave 10% or more of their net estate to charity may qualify for a reduced IHT rate of 36%.
Relief from IHT
Relief from IHT is available for certain types of asset, subject to certain qualifying criteria.
There is presently a very generous IHT regime for business and agricultural property, which can offer 100% relief from inheritance tax. Assets of the business as well as land and buildings used for the business may also qualify for the relief.
Broadly speaking, any interest in a business owned by a sole trader or partner, or shares in an unquoted company, will qualify for business property relief at 100% provided the following conditions are satisfied:
(i) the business or company is trading and is not an investment company or business
(ii) the interest in the business or shares in the company have been owned for at least two years
(iii) there is no binding contract for sale of the interest in the business or shares on death
(iv) there are no large cash surpluses or investments in the business or company not required for the future use of the business.
Investment in unquoted companies and businesses carries a higher degree of risk than quoted investments but can have very significant IHT advantages.
There are specific requirements to qualify for these reliefs and specialist advice should be taken wherever they or other reliefs (as listed above) may apply.
Gifts with reservation of benefit (GROBs)
For a lifetime gift to be exempt from IHT, the donor must make the gift without strings attached. If the donor retains a benefit or enjoyment in the asset gifted, it will remain part of his or her estate for IHT purposes.
Lifetime gifts that remain part of the donor’s estate for IHT purposes are called gifts with reservation of benefit (GROBs), as opposed to gifts genuinely given without the retention of a significant benefit or enjoyment are potentially exempt transfers (PETs).
To understand the distinction, consider the following scenario. John gives his home to his three children, transferring the legal title into their joint names.
- If John continues to live in the property rent-free, it will be deemed a GROB and remain part of his estate for IHT purposes.
- If John moves out or pays his children full market rent (thus releasing his reservation), it will be classed as a PET.
To be deemed a PET, the gift must be enjoyed to the ‘virtual exclusion’ of the donor. This means there is some room for a very minor reservation of benefit. In the aforementioned scenario, where John has given away his home, an example would be where John moves out but occasionally visits or stays at the property temporarily.
It is also worth noting that there is no GROB where a gift is exempt from IHT, for example, if the gift were to a spouse or civil partner.
Pre-owned assets charge (POAC)
As an extra measure to combat tax avoidance, in 2005 the government introduced the pre-owned assets charge (POAC). This applies to property given away, or property derived from such property, that the donor subsequently benefits from. It includes buildings, land, chattels and money and investments.
In cases where this applies, the donor will have to pay an annual income tax charge in relation to the benefit they receive from the property, unless they have elected for the property to be taxed as a GROB. To declare the property as a GROB, they must make the declaration by 31 January following the tax year in which they first became liable to POAC for the said property. There are a number of exclusions and exemptions from POAC.
A well-drafted Will is a key element to any individual’s IHT planning. With the help of a specialist solicitor you can structure your Will to minimise your IHT liabilities. Your Will should be reviewed at regular intervals to ensure it remains suitable in light of changes in your circumstances and taxation changes.
A trust enables a person (the ‘settlor’) to give away assets while stipulating that they are dealt with in a certain way. The settlor will name one or several trustees, to whom legal ownership of the assets (the trust property) is transferred. The trust will name the beneficiaries (those who will benefit from the trust assets and/or income generated from them) and how the trust will function. The trustees must manage the assets according to the terms of the trust. A settlor can create a trust during their lifetime (under a deed of trust) or can arrange via their Will for a trust to be set up when they die.
There are many different types of trust, which are effective in different circumstances. There are also many IHT and other tax issues that can be relevant to the creation, administration, termination or amendment of trusts, which are beyond the scope of this note. Our specialist solicitors can advise you whether setting up a trust would be useful for you.