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Inheritance Tax Nil Rate Band
At the present time, everybody individual permanently 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 you die, that the first £325,000 of your estate is free from Inheritance Tax.
All assets worldwide over and above the single Nil Rate Band of £325,000 are subject to Inheritance Tax at a flat rate of 40% in the Pound.
Assets That Do Not Form Part Of Your Taxable Estate
It might be that there are certain assets (such as your pension or other assets in trust) that might not technically form part of your taxable estate on your death, and if these sorts of assets exist, then your potential Inheritance Tax liability might be lower. It might be worth checking with your financial adviser to identify if there are any assets that don’t form part of your 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 and so long as the value of their estate is less than £2,000,000.
This RNRB allowance is initially £100,000 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 irrelevant 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 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 invoke stringent conditions here;
- Charitable Relief – there is no Inheritance Tax payable on any gift left to a registered charity irrelevant of the amount.
Potentially Exempt ( Lifetime ) Transfers/Gifts ( PETs)
One of the ways to minimise your 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 your estate to calculate Inheritance Tax if you die within seven 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 three years following the making of the gift and then reduces falling away altogether on the seventh anniversary of the gift being made. Inheritance Tax payable on gifts is payable by the recipient of the gift and not by your estate.
One option open to you would be to gift a proportion of your assets to your chosen beneficiaries and if you survive seven years, the gifts will be free of Inheritance Tax. These are called Potentially Exempt Transfers (PETs).
Legally, you have 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 your estate on death). Further, you lose control of them and if you change your mind in the future you will not be able to claim them back.
You are able to make small gifts called Exempt Transfers in any one tax year which will not fall back into your estate to calculate Inheritance Tax even if you die within seven years of making the gift. The amount is small, but you are able to gift £3,000 in any one tax year and this can each be backdated in the first year of giving by one year.
In other words, you can gift £6,000 (if you have not done so before) in the first year of giving. The allowance is to be divided between the beneficiaries and is not for each beneficiary. You can also gift £5,000 on marriage to beneficiaries and as many gifts of £250 to as many people as you like in any one tax year as long as they are to all different persons.
As with any gifts, including Potentially Exempt Transfers, a written record should be made. You might want to consider making use of exempt gifts every year from now onwards.
Gifts out of Surplus Income
If you are in a position where your income is greater than your outgoings, then you are able to gift surplus income, and this does not fall back into your estate to calculate Inheritance Tax should you 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 you would need to make a detailed schedule of all your income and outgoings. The schedule of outgoings would need to include everything that you can think of from hairdressing to spending on holidays, food, utility bills, golf club fees and clothing. You would also need to show a 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, you would not only keep control of them but after seven years any asset placed into the Trust will be free of Inheritance Tax.
Placing assets into a Lifetime Trust is not something that you should do 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. You can be both the Settlor, the person making the gift, and the Trustee, the person managing the Trust and therefore retain control.
However, on the negative side, once you have placed an asset into a Lifetime Trust, you cannot benefit from the asset yourself in any way. Further, 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 flat rate of 6%.
You can set up 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 you set 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 your estate for Inheritance Tax purposes if you have spare assets that you don’t feel you will need to rely and call on in your future years and you want to lock down 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 works only 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 irrelevant of the value of the gift. Therefore, if you were to set up an IPDI Will Trust, and then your death, if all of your assets were transferred into an IPDI Trust of which Linda (as your 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 would be to whatever beneficiaries you like.
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 liability to Inheritance Tax.
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 far and wide-ranging powers of how to deal with and distribute deceased spouse share of assets. You would normally leave with your Will a Letter of Wishes that would state how you would like the trustees of an IPDI Trust to administer the terms of the trust and who and how much of the assets to pay them to. Obviously, a major priority would normally to ensure that your 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 absolutely 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 on 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) then the remaining capital assets would on the spouse’s death pass to the default beneficiaries are 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 even remarried, 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 of 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 change and basically “do the right thing” dependent 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
I hope we’ve given you some food for thought and that this information is of some use. Can we stress 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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My name is Adrian Chambers. I am a lawyer who specialises in creating and preparing Wills.
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