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When someone dies the government will want to know the value of their estate in order to assess whether any Inheritance Tax is payable on the estate. Inheritance Tax is basically a “Death Tax” and is charged on certain estates if they are over a particular value.
Nil Rate Band
At present, every permanent resident within the United Kingdom has an individual Inheritance Tax (“IHT”) free allowance of £325,000, known as the Nil Rate Band. This means that when someone dies, the first £325,000 of their estate is free from Inheritance Tax.
All assets worldwide over and above the single Nil Rate Band of £325,000 are potentially subject to Inheritance Tax at a flat rate of 40% in the Pound.
Assets That Do Not Form Part of a Taxable Estate
It might be that there are certain assets (such as a pension or other assets in trust) that might not technically form part of a taxable estate on death, and if these sorts of assets exist, then they might not be taken into account for the purposes of assessing the estate’s liability to pay Inheritance Tax. It might be worth checking with a solicitor or financial adviser to identify if there are any assets that don’t form part of a taxable estate.
Residence Nil Rate Band
From 6th April 2017, an additional Residence Inheritance Tax Nil Rate Band (RNRB) was made available to individuals who own a home or a share of one, so long as their home is left to their direct descendants (children or grandchildren) and so long as the value of their estate is less than £2,000,000.
This RNRB allowance is initially £125,000 but will increase up to £175,000 by 2020. This means that by April 2020 an individual who owns a share in a home and leaves it to their descendants will be entitled to the Basic Nil Rate Band of £325,000 plus the Residence Nil Rate Band of up to £175,000 giving a combined Nil Rate Band allowance of £500,000.
There is no Inheritance Tax payable on gifts passing on death between married couples or civil partners irrespective of the value of the gift. This is known as “Spouse Exemption”.
For married couples or civil partners, in most circumstances, the individual Nil Rate Band of £325,000 can on death be transferred to the surviving spouse/partner giving a combined Inheritance Tax Allowance or Joint Nil Rate Band of £650,000.
However, if spouses leave everything to each other, that can result in the “bunching together” of their combined assets and if the combined assets remain in the hands of the surviving spouse and were currently more than £650,000 (£325,000 x 2 of the Nil Rate Band) or £1,000,000 (£500,000 x 2 of the Nil Rate Band and the Residence Band) then there would be Inheritance Tax to pay on the second death.
Other IHT Allowances
There are also other Inheritance Tax allowances potentially available which are as follows:-
- Agricultural Property Relief (APR) – there is no Inheritance Tax payable on certain farmland and buildings including forestry;
- Business Property Relief (BPR) – there is no Inheritance Tax payable on a trading company in certain circumstances. This does not include property management companies;
- Heritage Relief – there is no Inheritance Tax payable on assets which are of national or historical importance, but HM Revenue & Customs enforce stringent conditions here;
- Charitable Relief – there is no Inheritance Tax payable on any gift left to a registered charity regardless of the amount.
Potentially Exempt (Lifetime) Transfers/Gifts (PETs)
One of the ways to minimise an Inheritance Tax liability is the use of lifetime gifts. During your lifetime, you can give as much as you like to whomever you like and there will be no tax payable at the point of giving. These are known as Potentially Exempt Transfers (PETs).
However, the value of the gift will be called back into a person’s estate to calculate Inheritance Tax if that person dies within 7 years of making the gift. The Inheritance Tax on gifts is, however, tapered; in other words, full Inheritance Tax is payable on a gift for the first 3 years following the making of the gift and then reduces falling away altogether on the 7th anniversary of the gift being made. Inheritance Tax on gifts is payable by the recipient of the gift and not by the estate.
One option open to you would be to gift a proportion of your assets to chosen beneficiaries and if a person survives seven years, the gifts will be free of Inheritance Tax. These are called Potentially Exempt Transfers (PETs).
Legally, a person needs to be a little careful with how technically and legally any asset gift takes place to avoid any “Gift with Reservation of Benefit” rules.
PETs must be unconditional (otherwise they will still be treated as part of a person’s estate on death). Furthermore, the person loses control of them and if they change your mind in the future they will not be able to claim them back.
It is possible to make small gifts called Exempt Transfers in any one tax year which will not fall back into an estate to calculate Inheritance Tax even if a person dies within seven years of making the gift. The amount is small, but a person is able to gift up to £250 to as many individuals (up to a maximum of £3,000) in any one tax year and each gift can be backdated in the first year of giving by one year.
In other words, a person can gift £6,000 (if they have not done so before) in the first year of giving. The allowance is to be divided between multiple beneficiaries.
A person can also gift £5,000 on marriage to their children (and lesser amounts to more distant relatives) and as many gifts of £250 to as many people as they like in any one tax year as long as they are all to different people.
As with any gifts, including Potentially Exempt Transfers, a written record should be made. A person might want to consider making use of exempt gifts every year from now onwards.
Gifts for Living Costs
Inheritance Tax may not be payable on gifts that are provided to support the living costs of the beneficiary e.g. the education of a child under 18.
Gifts out of Surplus Income
If a person is in a position where their income is greater than their outgoings, then they are able to gift surplus income, and this does not fall back into their estate to calculate Inheritance Tax should they die within seven years of making the gift.
To be able to qualify for gifts out of surplus income as you may imagine HM Revenue & Customs have laid down some strict guidelines. First of all, every year a person would need to make a detailed schedule of all their income and outgoings. The schedule of outgoings would need to include everything that they can think of from hairdressing to spending on holidays, food, utility bills, golf club fees and clothing. They would also need to show a regular pattern of giving over a number of years, but it is potentially a way to reduce Inheritance Tax without falling foul of the seven-year rule.
One of the most useful tools to try to minimise an Inheritance Tax liability is the use of Lifetime Trusts. By placing assets into a Lifetime Trust for the benefit of your beneficiaries, a person would not only keep control of their assets but after seven years any asset placed into the Trust would be free of Inheritance Tax.
Placing assets into a Lifetime Trust is not something that should not be done without a great deal of thought and advice.
The safest way to avoid any Lifetime Trust tax liability is to place an asset of a value of up to £325,000 each into a Lifetime Trust every seven years. The person can act both as the Settlor (the person providing the gift) and the Trustee (the person managing the Trust) and therefore retain control.
However, on the negative side, once a person has placed an asset into a Lifetime Trust, they cannot benefit from the asset in any way. Furthermore, any income earned will normally be subject to Income Tax at the highest rate, presently 45%.
Setting up a Lifetime Trust of up to £325,000 would be subject to a periodic tax, and if the assets in the Trust were to go over £325,000 in any ten-year period then the excess over the £325,000 would be taxed at a flat rate of 6%.
A person can set up a Lifetime Trust with a value in excess of £325,000, but any amount over the £325,000 would be subject to an entry tax of 20%. Therefore, if a person sets up a Lifetime Trust of say, £500,000 then the first £325,000 would be tax-free but the balance of £175,000 would be taxed at 20% amounting to £35,000.
Basically, Lifetime Trusts are a useful way of reducing the value of a person’s estate for Inheritance Tax purposes if you have spare assets that you don’t feel you will need to rely upon in the future and if you want to secure a sum of money for a particular beneficiary.
Immediate Post Death Interest Trust (IPDI)
The use of an Immediate Post Death Interest Trust (IPDI Trust) within a Will is another way in which, by careful drafting, a spouse can indirectly minimise the Inheritance Tax payable on their estate.
However, an IPDI Trust only works for married couples or civil partners by using the Spouse Exemption referred to earlier.
Basically, there is no tax payable on gifts passing between married couples or civil partners on death irrespective of the value of the gift. Therefore, if a person was to set up an IPDI Will Trust and all their assets were transferred into it, of which their surviving spouse has first call, then no Inheritance Tax is initially payable.
The Trust created within the IPDI Will can contain powers of appointment and advancement for the Trustees so that they will be able to gift money to persons other than the surviving partner. This can be to any beneficiary.
Any gift out of the IPDI Trust is deemed to be a gift by the surviving spouse and therefore will not attract Inheritance Tax on first death and so long as the spouse survives for seven years, will not attract Inheritance Tax on second death either.
The Finance Act 2008 introduced the use of such Trusts and allows for such Trusts to fall outside of what is known as the “Relevant Property Regime”. This means that any monies held in the Trust will not be subject to periodic tax charges as usually apply in the case of a Lifetime Trust above, nor any tax on exit or when gifts are made.
The surviving spouse would be entitled to capital and income. Crucially, any gift by the Trustees out of the trust during the surviving spouse’s lifetime can only be made with the surviving spouse’s consent.
These types of trusts are very popular with married couples and whose estates are in excess of the Inheritance Tax Nil Rate Band limits and therefore could have a potential Inheritance Tax liability.
IPDI Wills provide an opportunity of not just saving or potentially completely avoiding paying Inheritance Tax, but also retaining a degree of flexibility and control over your assets as well.
The Trustees of an IPDI Will usually have wide-ranging powers over how to deal with and distribute a deceased spouse’s share of assets. A person would normally leave with their Will a Letter of Wishes that would state how they would like the trustees of an IPDI Trust to administer the terms of the trust and whom and how much of the assets to pay them to. Obviously, a major priority would normally be to ensure that the surviving spouse’s best interests are looked after and that they are financially secure.
It would only be when the trustees are satisfied that the surviving spouse is financially secure that the trustees might want to consider making distributions of money to other beneficiaries. Such distributions can only be made with the consent of the surviving spouse.
Benefits Of An IPDI Will Trust
There are three main benefits to making an IDPI Will Trust. These include:
- INHERITANCE TAX SAVINGS
There are Inheritance Tax savings that can be achieved with an IPDI will Trust. To make the most of any potential Inheritance Tax savings, then any gift out of the Trust to other beneficiaries must be made within two years minus one day of the date of death, so there is plenty of time for the surviving spouse and the trustees to think about this and make the right financial decisions.
Basically, what normally happens after the first death is that the surviving spouse together with, say, a lawyer and an accountant, would assess the extent of the assets and liabilities of the estate and how much in regard to both income and capital the surviving spouse would need to maintain their normal lifestyle. On the assumption that the survivor would not need all of the capital and income, then potentially, a proportion of the assets could be appointed or gifted from the trust to other beneficiaries.
Under the Finance Act, these gifts would be deemed to be lifetime transfers from the surviving spouse to the other beneficiaries and so long as the survivor then lived for a further seven years after making the gift they would be completely free from Inheritance Tax.
In other words, after the first death, if the surviving spouse did not need all of the combined assets and the trustees decided to gift for example £100,000 to other beneficiaries, then the potential saving on Inheritance Tax upon the second death would be £40,000.
However, whatever gifts have been made from the trust (or even if no gifts were made from the trust) the remaining capital assets would, on the spouse’s death, pass to the default beneficiaries that you have chosen (subject to any Inheritance Tax payable on the balance).
- PROTECTING ASSETS
An IPDI Will Trust enables the assets of the person who dies first to be protected and managed by the trustees on behalf of the surviving spouse and any other beneficiaries.
Therefore, if the surviving spouse was to form a new relationship or remarry, or was to face bankruptcy, then the deceased’s half share is protected and would not be at risk of passing outside of the family.
With an IPDI Will Trust, you can not only retain a degree of control over the assets but you can also give your trustees the flexibility and discretion to manage and distribute the deceased’s share of assets to ensure they pass to the right persons in the future. Some potential future beneficiaries may behave in a way that you might not feel is appropriate or they may fall into unfortunate circumstances where receiving an inheritance might not be in their personal best interests (bankruptcy, or an unhappy marriage or even divorce).
An IPDI Will Trust provides the flexibility and discretion to enable your trustees to adapt and “do the right thing” based on changing future events that might occur after you have passed on.
- TRUST TAX SAVINGS
Normally when a Discretionary Trust is set up in a will then it is treated by the Inland Revenue as being a “Chargeable Transfer” and falls into what is known as the “Relevant Property Regime”. This can usually lead to excessive tax rates being charged. For example, any income generated from the trust in excess of £1,000 is charged at 45%. There are also trust entry, exit and 10-yearly tax charges.
However, because an IPDI Will Trust is not treated by the Inland Revenue as a “Chargeable Transfer” and is automatically excluded from the Relevant Property Regime then all of the potential tax charges that would normally arise with a Discretionary Trust are avoided.
Food For Thought
We hope we’ve given you some food for thought and that this information is of some use. Can we stress that there is no right or wrong answer in these situations. It’s entirely up to you. You may want to pick and mix and go for a combination of the above options.
Please feel free to take whatever you can from this. At the end of the day, it’s entirely your decision based on what you personally want.
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Inheritance Tax Specialists
I’m Adrian Chambers and specialise in Probate and Estate matters. We aim to provide our clients with an outstanding legal service.
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