Inheritance Tax Rules

The current (tax year 2011/12) Inheritance Tax (“IHT”) allowance (technically known as the Nil Rate Band or “NRB”) is £325,000 (and this is not expected to change until April 2015). Everyone has this allowance and this means that gifts up to this amount may be made without incurring IHT. Any Estate valued in excess of the NRB is taxed at 40% on the excess.

An Estate consists of all worldwide assets and includes transfers made before death. However, there are exceptions:

• Under current Inheritance Tax rules transfers between spouses and civil partners are free of Inheritance Tax (provided the spouse/civil partner of a deceased UK domiciled person is also UK domiciled – otherwise the maximum exempt transfer is £55,000).
• Any transfer made more than 7 years before death is free of IHT*. There is a sliding scale of IHT for cumulative non-exempt transfers in excess of the NRB made in the 7 years before death, (i.e. 100% of IHT rate for excess transfers made within 3 years of death, 80% of Inheritance Tax rate for excess transfers made between 3 and 4 years of death, 60% of IHT rate for excess transfers made between 4 and 5 years of death, 40% of Inheritance Tax rate for excess transfers made between 5 and 6 years of death, 20% of IHT rate for excess transfers made between 6 and 7 years of death). n.b. lifetime chargeable gifts (e.g. to a discretionary trust) made within 14 years of death may still count towards the NRB. [See examples later on.]
• Wedding gifts: up £5,000 to children, £2,500 to grandchildren (or remoter issue) and £1,000 to others.
• Gifts up to £250 to an individual in a tax year (£250 is total during year)*.
• Gifts over £250 to individuals in a tax year, up to a total of £3,000 in a tax year*. (Can be to one person or to several people). If this exemption is not fully utilised in one tax year the unused portion can be carried forward to the next tax year (after that year’s allowance has been sued).
• Donations to registered UK charities, bodies such as National Trust etc. or recognised political parties.
• Regular transfers made from taxable income (provided your standard of living is not reduced).
• Overseas assets are excluded from the Estate if you are not UK domiciled.
• Certain business assets and agricultural land if owned for at least 2 years. (For more detail see Business Succession Planning.)

* a gift with reservation (i.e. a gift made during the lifetime of the Donor but the Donor retains the benefit of the gift, e.g. a house given by a parent to the children but the parent stays in the house without paying a reasonable level of rent) does not count as a transfer and the gifted property is deemed to remain an asset of the Donor.

Transferable Nil Rate Band (“NRB”)

Since 9 October 2007 the unused portion of a person’s NRB can be used by their spouse or civil partner on their death. This does not mean that the NRB has increased from £325,000 but it does mean that on the surviving spouse’s (or civil partner’s) death the NRB could be doubled.

A simplified example will show how it works. A husband dies and leaves £130,000 to his children and the rest to his wife. He has used 40% of his transferable Nil Rate Band in the gift to the children. Later, when the wife dies she can have 160% of the Nil Rate Band at that time. So, if the Nil Rate Band has increased to, say, £400,000 at that time, she can give away £640,000 without paying IHT. So in total the husband and wife could give away £770,000 without paying Inheritance Tax. (If the husband had not given anything to the children on his death the wife could give them up to £800,000 on her death without paying IHT).

The new rules apply even if the first to die died before 9 October 2007 (but the survivor must have died on or after 9 October 2007). But there may be complications if the first death was before 1972.

The new rules also apply if someone has been widowed more than once and apply to each previous spouse or civil partner (must have been married to the spouse/civil partner at the time of death), but the total transferable Nil Rate Band on 2nd death cannot be increased by more than 100%.

The uplift in the Nil Rate Band on 2nd death is not automatic and has to be claimed (and the amount of NRB used on first death has to be proved). This means that on all deaths now detailed records need to be kept of the NRB used so that any unused portion can be claimed in the future. This means that Probate needs to be carried out carefully.

Lifetime Transfers

As seen above, transfers made during a person’s lifetime will be added to the Estate on death if the transfers were made in the seven years before death. For this reason they are called Potentially Exempt Transfers (or “PETs”). However, transfers into certain trusts (typically discretionary trusts) are not only PETs but they are also subject to IHT immediately at half the full rate of IHT on the value in excess of the NRB. So putting £400,000 into a lifetime discretionary trust will incur immediate IHT of £15,000. Further IHT may be payable on the £400,000 if the donor dies within seven years of the transfer (but there will not be a rebate if the donor dies after seven years).

Potentially Exempt Transfers (“PETs”)

Thus is an area that is misunderstood by many people. As shown above, transfers made within seven years of death are added to the deceased’s estate at death for the purposes of Inheritance Tax. However the Inheritance Tax payable on these transfers may be reduced. An example will show this.

Two people, A and B, have £744,000 each in assets and decide to start planning for Inheritance Tax by giving away £93,000 each year. A dies exactly 7 years after starting his plan and B dies exactly 3 years after starting his plan. The Inheritance Tax for each is calculated as follows (assuming no change to the NRB and no change in value of the assets):

* after the £3,000 annual exemption

Total Inheritance Tax paid is £156,400.

The Inheritance Tax payable in years 4 to 7 is due from the recipients of the gifts. Therefore recipients of sizeable lifetime gifts should take out decreasing term (7 years) life assurance on the life of the donor to cover the potential Inheritance Tax payable.

If no gifts had been made in the seven years before death, the Inheritance Tax payable on an estate of £744,000 would be £167,600. It can be seen that A only saves IHT on the annual £3,000 exemption and on the payment in year 4. B only saves Inheritance Tax on the annual £3,000 exemption.

In fact if A (or B) had died after 8 years using this plan of annual gifts, the total Inheritance Tax payable would be £119,200, after 9 years it would be £83,200, after 10 years it would be £47,200 and after 11 years it would be £11,2000. After 12 years there would be no Inheritance Tax payable at all.

The above examples assume that no gifts were made into a discretionary trust.  This complicates the calculations and could lead to gifts up to 14 years before death being taken into account.

Anniversary and Exit Charges

Any trust that is subject to Inheritance Tax (typically discretionary trusts), whether set up in the donor’s lifetime or on death via a Will, has further IHT payable on every tenth anniversary of setting up the trust and when assets are removed from the trust.

The calculation of the Inheritance Tax payable is complicated but in simple terms the ten year anniversary Inheritance Tax is 6% of the value of the assets in excess of the NRB at the anniversary (allowing for any distributions from the trust in the previous years).

The Inheritance Tax payable on exit from the trust is based on the average rate of Inheritance Tax paid at the previous ten year anniversary and the length of time since the last ten year anniversary.

An example shows how this works:

£500,000 is put in a discretionary trust. £125,000 is taken out after 3 years and the remaining assets grow to £475,000 after ten years. The NRB at outset is £325,000 and is £400,000 after ten years.

The notional Inheritance Tax anniversary charge at outset is 6% of (£500,000 - £325,000) = £10,500. This equates to 2.1% of the original £500,000. The Inheritance Tax payable on the £125,000 taken out is 3/10 x 2.1% x £125,000 = £787.50 (3/10 because the £125,000 is taken out 3/10ths of the way through a ten year period.)

The NRB available on the tenth anniversary is £400,000 - £125,000 = £275,000. The ten year anniversary Inheritance Tax charge is 6% of (£475,000 - £275,000) = £12,000. This is 2.53% of the value of the assets and any asset taken out of the trust in the next ten year will suffer Inheritance Tax at this rate (pro rata for the period after the tenth anniversary)

The amount of Inheritance Tax payable on ten year anniversaries can be reduced (or removed) by the use of Pilot Trusts.

Inheritance Tax Saving Wills for Married Couples (or Civil Partners)

Discretionary trusts can be used in Wills to reduce the impact of Inheritance Tax (especially on later death). Such circumstances might be:

• Second or subsequent marriages where a parent wants to look after children from a previous marriage as well as his current spouse (or civil partner) or to protect his children if his spouse should remarry
• Where the assets being given away are expected to grow faster than the increase (if any!) in the Nil Band Rate
• In marriages (or civil partnerships) where one of the partners has been widowed. It is possible to use trusts in Wills to protect up to £975,000 (£1,300,000 if both partners have been widowed) from Inheritance Tax.
• In first marriages (or civil partnerships). It is possible to use trusts to increase the amount that can be protected to £975,000 if one of the partners should remarry if they are widowed.

If it is thought that the children will require some inheritance before the surviving spouse (or civil partner dies). A Will can be used to set up a Flexible Life Interest Trust (“FLIT”). Under a FLIT the surviving spouse (or civil partner) receives the income from the assets in the Trust during their lifetime and the capital goes to the children (or other beneficiaries) on their death. However the Trustees of the FLIT have discretion to transfer some (or all) of the capital to the other beneficiaries at any time. The original transfer into the FLIT is counted for Inheritance Tax purposes as a gift to the surviving spouse (or civil partner), so no Inheritance Tax is paid then. Whenever the trustees appoint assets out of the Trust (or on the death of the surviving spouse (or civil partner)), for Inheritance Tax purposes it is considered as a gift by the surviving spouse (or civil partner). So if the surviving spouse (or civil partner) survives at least seven years after the appointment out of the trust, no Inheritance Tax will be payable on this gift (and if the surviving spouse (or civil partner) does not survive seven years after the appointment out of the trust, the Inheritance Tax payable may be less than it would have been if the surviving spouse (or civil partner) had left it on their death.

If a share of a house is to be put into a trust the owners must own it as Tenants in Common.

I can draft Inheritance Tax saving Wills.

IHT Saving Wills for Unmarried Couples (may be same-sex couples who are not civil partners)

Transferability of NRBs does not apply to unmarried couples (or same sex couples who are not civil partners).

Depending on the split of the assets between the partners, it will usually be necessary to first ensure that any house is owned by the partners as Tenants in Common. Beneficial Joint Owners each own 100% of the house and on the first death the house automatically passes to the surviving owners and in this case, whatever the Will of the deceased might say, his/her share of the house will automatically go to co-owner(s).

Tenants in Common each own a share of the house (usually 50/50) but the co-owners can each decide who inherits their share on their death in their Will.

A Deed of Severance will change ownership from Beneficial Joint Owners to Tenants in Common.

Wills for unmarried couples whose joint estate is worth more than the NRB (for an individual) should consider using a discretionary trust in their Wills (with their partner being a discretionary beneficiary). They can each put their assets up to the NRB in the trust on their death, thus safeguarding it from IHT when their partner dies. On joint Estates worth more than 2x the NRB this will save 40% of the NRB in Inheritance Tax (currently £130,000).

Note that i) there is no spouse (or civil partner) exemption for unmarried couples or same-sex couples who are not civil partners - thus Inheritance Tax will still be paid on the first death on estates worth more than the NRB and ii) the discretionary trust for unmarried couples lasts for 125 years, therefore the surviving partner cannot take the entire estate after 2 years if the trustees do not arrange the trust to his or her liking within 2 years.

I can draft Inheritance Tax saving Wills.

Pilot Trusts

A discretionary trust is subject to ten year anniversary Inheritance Tax charges and exit charges (see Anniversary and Exit Charges). If this is likely to happen on a death (i.e. the value of the assets going into a trust from a Will exceeds the NRB or the value may exceed the Nil Rate Band at a future ten year anniversary) then the future Inheritance Tax charges can be avoided by the use of Pilot Trusts.

Every discretionary trust has its own Nil Rate Band, except if they are set up on the same day, in which case all the trusts set up on that day share one Nil Rate Band allowance (and this is the case on death).

So if it is likely that anniversary Inheritance Tax charges will be a problem the solution is to set up sufficient discretionary trusts in your lifetime (on different days) to be able to accept the transfers under the NRB but totalling the expected gift from the Will. These trusts are called Pilot Trusts.

Pilot Trusts are extremely useful for business assets, as any future sale proceeds can be broken up into tranches of less than the Nil Rate Band and therefore retain nil rate Inheritance Tax.

Note that Pilot Trusts do not remove the Inheritance Tax on death on any gift over the Nil Rate Band if the gift is not exempt from Inheritance Tax.

I can arrange for Pilot Trusts to be established.

Property

If there are two or more owners of a property there are two ways in which it can be owned.

The most usual way of owning a property jointly is as Beneficial Joint Owners (most married couples own property this way). On the death of one of the owners the property passes to the other owners automatically, regardless what any Will might say (this also applies to joint bank accounts).

The other way of owning a property jointly is as Tenants in Common. Under this method each owner owns a particular share (usually but not necessarily equal) of the property. On the death of one of the owners they can give their share of the property in their Will to whoever they wish (or into a trust).

Thus, if a property is owned jointly and is to be part of tax planning or care fee planning, it must be owned as Tenants in Common for such planning to be effective.

I can arrange for properties to be converted from Beneficial Joint Ownership to Tenants in Common.

Inheritance Tax rules specialist

It is essential to have good independent professional advice before embarking on any course of action, which is where I come in.

Please contact me if you need assistance in any of the areas above.