Reducing the inheritance burden

MONEY TALK
By Mike Warburton
Senior Tax Partner, Grant Thornton

Inheritance Tax has progressively become a tax on the many rather than a burden borne exclusively by the rich, a leading tax expert writes.

Inheritance Tax was originally introduced as Capital Transfer Tax by the new Labour Government in 1975, with a top rate of 75%.

It was, however, only intended to catch the rich. It was also carefully structured to make it difficult for rich people to avoid it, and to that extent was argued to be fair.

Over recent years, however, there has been a concern that it has become anything but fair and, in particular, is affecting ordinary people who would certainly not regard themselves as rich.

Rising asset values, particularly house prices, coupled with inadequate increases in the Inheritance Tax threshold, means that more and more people are facing the prospect of Inheritance Tax when they eventually pass away.

In the future, more than one in 10 families will be caught by the tax.

Wider net

The essential problem is that the people caught are those in the middle - anyone who has an estate worth more than £255,000 is affected.

This is because the value of the assets you leave behind on death, apart from the first £255,000, are taxed at 40%.

Both major political parties have recognised that the position is unfair, but have done relatively little about it.

So the question is what can you do about it.

The first thing for people to do is to make sure they have an up-to-date will, and preferably one which enables both spouses to utilise their nil rate threshold.

If, on the first death, all assets are passed to the surviving spouse, no tax will be payable at that stage, but on the death of the surviving spouse anything over the nil rate band will be caught for tax.

Discretionary trust

A simple alternative, if surplus funds are available, is for the first spouse to leave, under the terms of their will, a nil rate band discretionary trust.

In effect, up to the £255,000 nil rate band passes into trust on the first death on terms that enable the surviving spouse to access income or capital of the trust on a discretionary basis, but where it is not regarded as part of his or her estate.

A solicitor can easily structure this into the will when it is drafted, or as a codicil to the will.

It is very important, if this step is to be taken, that each spouse has sufficient investments in their own name to pass into the discretionary settlement on death.

But remember that assets owned jointly, such as a joint bank account, will automatically pass to the surviving spouse regardless of what is said in the will.

It is often the case that there are insufficient investments, or other liquid assets to be able to set up a trust in this way, particularly where the bulk of the assets held are in the family home.

A simple solution here is to ask your solicitor to include a debt clause in the will which has the effect of using the nil rate band on the first death even if the property remains in the ownership and use of the surviving spouse.

It is important, in these circumstances, to split any joint tenancy on the property so that the couple own the property as tenants in common.

On first death, the effect of the debt clause is that the house will pass to the surviving spouse, but subject to a debt payable to the trust set up on death, up to an amount of the nil rate band, or half the value of the property, whichever is less.

In simple terms, it is as if half the house was left to the trust and then sold to the surviving spouse in exchange for a debt. Legally, it doesn't work quite this way, but that is the end result.

Pension funds

Where people have been able to build up an adequate pension fund to give an income, it may be possible to pass some surplus investments down to your children, or in trust to your children, by using the seven-year rule.

Gifts made to individuals, life interest trusts, or accumulation and maintenance trusts count as potentially exempt transfers and will not have any effect on inheritance tax as long as the person making the gift lives a further seven years.

Between three years and seven years there is a form of inheritance tax taper relief, but this is a rebate on tax payable, not the amount of the gift.

An opportunity exists, particularly up to this December, to remove the value of your house from your Estate Mike Warburton

If, therefore, you made a gift of £255,000 and died six years later, no relief would be due. If the gift were £355,000, however, there would be an 80% discount on the tax due on the £100,000 balance of the gift over and above the nil rate band.

Most people know that you can gift £3,000 a year without inheritance tax applying at all. This gift applies for both husband and wife and you can also pick up the £3,000 from last year if it was not utilised.

What is less well-known is that there are no limits to the amount of gifts that can be made tax free in this way, as long as they are regular, out of income, and do not reduce your standard of living.

For example, my mother paid £20,000 a year in the last five years of her life on grandchildren's school fees without it affecting her inheritance tax position at all.

Family home

A major problem with inheritance tax planning is the "Reservation of Benefit Rule" which means that, even if you give an asset away, it is still treated as part of your estate if you continue to benefit from it.

This might, for example, apply if you give away a house to your children, but continue to live in it, or receive rental income from it.

Bright minds have devised complex schemes to get around this rule and until last April a complicated loophole existed using what are known as defeasible life interest trusts.

The Chancellor didn't like this and closed the loophole in this year's Finance Act.

You will need to plan ahead and take professional advice Mike Warburton

Nevertheless, it is often possible to get around the rule in individual family circumstances with bespoke tax planning using trusts and, if the amounts are large enough, it is worth taking professional advice on the way to achieve this.

In the meantime, an opportunity exists, particularly up to this December, to remove the value of your house from your estate whilst continuing to live in it under what is known as the Home Loan Scheme.

In this arrangement, you sell your house to a property trust in which you benefit, on deferred terms, and then given away the debt to a family trust, typically for the benefit of your children.

As long as you live a further seven years, the current value of your house effectively drops out of your estate because it becomes a debt due from your estate to your children's trust.

The planning is complicated and can be expensive, but the savings can be enormous.

Unfortunately, changes in this year's Finance Act on stamp duty mean that, after 1 December, stamp duty will be payable on the sale of the house to the trust which in many cases will make the arrangement too expensive to operate.

In summary, there are, fortunately, many ways of reducing the impact of the tax, but you will need to plan ahead and take professional advice.

The views expressed are solely those of Mr Warburton and are for general information only. They do not constitute financial advice as defined by the Financial Services Act and are not intended to be relied on for the purposes of making an investment decision.

Always obtain independent advice from a qualified, registered tax or financial adviser before making any investment decisions.