A basic guide to avoiding Inheritance Tax (IHT) (2021/2022)
Monday 3rd May, 2021
Inheritance Tax is without a doubt the most controversial and confusing of taxes, with many people unsure of whether their estate will be subject to the 40% Inheritance Tax charge or not. There are difficult concepts such as the Nil Rate Band, Residential Nil Rate Band, gifts with reservation and the IHT 7 year rule, which make it hard for anybody to navigate the complex IHT rules.
Many people feel that IHT is unfair, as they have paid taxes all their lives and therefore shouldn't be taxed at death as well. Inheritance Tax for landlords with large property portfolios can be particularly difficult to manage and can leave their executor with a difficult and costly IHT problem. Their main concern is to pass their estate over to their loved ones as efficiently as possible and therefore want to know how to avoid Inheritance Tax (IHT) and reduce their IHT bill.
This article will provide a step by step process to putting in place a plan that can help you to reduce your IHT bill carefully and effectively.
Inheritance Tax (IHT) and Estate Planning is one of my favourite areas of financial planning. It’s not because I have a penchant for the macabre or find anything particularly enjoyable about planning for death. It is more that the plan itself can be fairly creative and there can be a number of possible solutions to achieve the intended outcome.
Despite this, I still use a basic structure whenever I am planning. I explained this to a client a few weeks ago and they found it incredibly useful, so I thought I would post the bare bones of my approach below. This is just a rough guide and isn’t intended to provide a solution to all your estate planning needs. IHT and Estate Planning remain very complex areas and it is crucial that you take advice from an experienced and suitably qualified professional.
Step 1: Wills and Powers of Attorney
The foundation of all estate planning is your will. The implications of intestate succession can quite often be horrendous and put your loved ones in a decidedly unpleasant situation at a point when they are often grieving and least able to deal with it.
By putting a will in place, you can make sure that your estate is divided up as efficiently as possible and that loose ends are minimised. By leaving a valid will you will help to keep probate and Inheritance Tax as simple as possible, while leaving your loved ones looked after and financially in the best shape possible.
You can also put in place measures that ensure that assets are passed on to your chosen beneficiaries long after your death. This is a situation which is seldom considered by people when drawing up their wills. For example, you can set up a trust to ensure that, upon death, your spouse will continue to benefit from your estate. You can also ensure that if your spouse was to remarry, your children would remain the beneficiaries of your estate, and not the children of his or her new partner.
A will can also be used to establish who the guardians of the deceased's minor children might be, should both parents die. It can ringfence assets to be used by the guardians to meet the cost of raising the children in order to alleviate the additional financial burden.
Don’t cut corners when putting your will in place. A will divides up the estate you have spent a lifetime building up. This is one area where paying a few extra pounds dealing with a qualified professional makes absolute sense.
When dealing with clients of all ages, we always recommend putting in place a Lasting Power of Attorney (LPA). An LPA is an insurance against losing mental capacity. If this happens, the LPA ensures that your affairs will be looked after by someone of your choosing and who has your best interests at heart. The alternative is to have the Court of Protection appoint a deputy to look after your affairs. This can be someone you wouldn't choose or a complete stranger, who may care about you, but knows nothing about your character and how you would like things done. This is not ideal for anyone.
I know that many people quite justifiably fear giving up control to someone else, but it is probably the wrong way to look at it. By putting in place an LPA, you are making sure that you retain as much control as possible. It is also important to note that long as you are lucid and capable of making decisions, the attorneys have to give credence to your wishes.
Step 2: Equalise estates
Take steps to equalise estates to ensure that each party to a marriage/civil partnership has sufficient assets in their own name available to meet their individual bequests as per their will.
This is a relatively simple process, as their is no Income Tax or Capital Gains Tax on transfers between spouses. It may involve things like switching the ownership of your main residence from joint tenancy to tenants in common, or moving certain investments or cash deposits into sole names. This can be a really useful exercise and is often the perfect opportunity to ensure that all assets are held as tax efficiently as possible.
Step 3: Exclude Inheritance Tax exempt assets
Some assets may qualify for IHT exemption due to various reliefs that are available, such as Business Property Relief and Agricultural Property Relief.
Agricultural Property Relief
Agricultural Property Relief (APR) is a relief from IHT on the agricultural value of UK agricultural property which has been:
- Owned and occupied by the owner for the purposes of agriculture for at least two years, or
- Owned for seven years, and occupied by the owner (or someone leasing the property) throughout for agricultural purposes.
APR is given at 100% if:
- The owner has vacant possession of the property or they have a right to vacant possession within 12 months.
- The land is let and the tenancy started on or after 1st September 1995.
50% relief may be available in other cases.
This is a very complex area and it is crucial that advice is taken. Do not simply assume that a piece of land qualifies by virtue of the fact that it is picturesque and there a few cows randomly grazing on the fields.
Business Property Relief
Business Property Relief (BPR) is a tax relief that was made available by the government in 1976 in order to:
- Encourage investment into certain types of trading businesses and;
- To prevent the sale and dissolution of family-owned businesses in order to pay IHT upon death of the owner.
Subject to this relief, holdings in qualifying businesses are exempt from IHT after being held for more than two years. BPR is available on:
- On an interest in a business or a partnership
- On unquoted shares and;
- On land, buildings, plant and machinery when utilised in a qualifying trading business.
It is important to speak to a specialist in this area, as I have often dealt with clients who have just assumed that their business qualifies for the relief, only to find out too late that this is not the case. This is particularly true of Family Investment Companies and Property Companies.
Step 4: Consider what you can afford to gift away. Is it income or capital?
Former Labour Chancellor Roy Jenkins famously described Inheritance Tax as ‘a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.’
While the sentiment is possibly tongue in cheek, the principle is sound. If you want to reduce your future IHT bill, reduce the size of your estate. How do you do this? Well, by gifting away assets you don't need in order to maintain your lifestyle and financial security. You can also take steps to avoid income building up in your estate by gifting away excess income.
However, there are things to consider when doing this. The first is, how much can you afford to give away without dramatically impacting your financial wellbeing? The easiest way to determine this, is by approaching a financial adviser and asking them to carry out some cash flow analysis to model the impact of certain scenarios, such as going into care or falls in the market, on your ability to maintain your lifestyle should you make the gift.
When you look to gift away surplus income or capital you should consider:
- First utilising all exemptions available. These include the £3,000 annual allowance we each have, as well as gifts out of excess income, which are immediately exempt for IHT purposes provided the gift meets certain minimum requirements.
- Should any further gifts be made outright or into trust? This is a crucial consideration. If you trust your propsective beneficiaries implicitly, have no desire to retain any control over the gifted assets and have no need to retain some sort of access to the gifted asset yourself; then simply gift it to your chosen beneficiaries outright. However, if you wish to protect the gifted assets from loss due to divorce or bankruptcy actions against the beneficiary, or it is important to you to retain control over how the assets are managed or distributed, or you simply need to retain some sort of access to the capital or income, then you probably need to consider a gift into trust.
- If into trust, will you need to retain access to the capital or carve out an income for yourself from the assets being gifted? Or, is the main purpose of the trust simply to protect the gifted assets from attack by third parties as a result of the beneficiary getting divorced or going bankrupt.
- If into trusts, what trust structure should you use? Once again, this will determine the level of control, protection and access to the assets the trust affords you.
Gifting assets away while alive is an important step that many people don't consider. You don't have to wait until you die to distribute your estate. You can make gifts to your children and gifts to your grandchildren during your lifetime. Provided you survive for the required 7 years, the value of the gifted assets will fall out of your estate for IHT purposes and reduce the size of your estate. Not only will this reduce your IHT liability, it will also allow you to see your loved ones benefiting from your gifts during your lifetime.
Step 5: Use Business Property Relief Qualifying Investments
Once all gifting has been completed, it is important to determine whether we can mitigate some IHT by using investments that qualify for Business Property Relief.
These are investments that, due to the structure of the investment, or the nature of its underlying investments, qualifies for Business Property Relief (BPR).
With these investments, you simply need to hold them for two years and they will qualify for BPR and become exempt for IHT purposes. In addition to exempting the assets from IHT far quicker than the 7 years required when gifting, they also allow the investor to retain access to the investments.
There are two types of investments that are utilised in these circumstances:
- Growth focussed investments, where the primary aim of the investment is to achieve high returns. They can be extremely volatile, but have incredible growth potential. These include AIM portfolios and Enterprise Investment Schemes. These are inherently risky and the qualification for BPR is simply an ancillary benefit.
- Investments focussed on achieving the BPR exemption and capital preservation. These investments are not growth focussed and tend to look at generating 3% - 4% per annum after charges. Their aim is to achieve a basic level of growth that retains the value of invested assets in real terms and exempts assets from IHT by qualifying for BPR within 2 years. Despite the focus on capital preservation, there is still a high level of risk involved. These investments have generally performed well in bear markets, but there is no guarantee that a set of circumstances won't come along that can cause their value to fall substantially. These are generically called Inheritance Tax Services (ITS).
BPR qualifying investments are very useful for rapidly exempting assets from IHT, particularly in cases where someone has been diagnosed with a terminal illness or has a restricted life expectancy.
They are also particularly useful in cases where a Lasting Power of Attorney is in place. In these situations, the attorney is generally prohibited from making gifts out of the donor's estate for IHT planning purposes. However, the attorney can still invest on behalf of the donor, which opens the door for utilising ITS to invest and exempt assets from IHT.
Step 6: Use Whole of Life Insurance to cover any excess Inheritance Tax liability
If there is any outstanding IHT liability, it is worth considering whether there is an option to cover this with a Whole of Life Insurance policy?
Putting in place life insurance to effectively pre-pay the future IHT liability can be a really effective strategy. If you write the policy in trust, it ensures that the proceeds of the policy don't form part of your estate on death and are therefore not subject to IHT. Furthermore, the proceeds can be distributed from the trust to the beneficiaries before probate is completed. This can alleviate concerns about who pays the Inheritance Tax and what assets should be used to do it.
It is hard to overstate what a useful tool Whole of Life Insurance can be, particularly in situations where the deceased has a large property portfolio or a number of other illiquid assets. The burden this type of situation puts on the family and executors is substantial. Remember, the estate cannot be distributed until the Inheritance Tax liability is paid. However, an executor is not permitted to sell a property or distribute any of the estate until a Grant of Probate has been received. This won’t take place until the executor has been issued with a receipt from HMRC which states the IHT has been paid. In many of these situations, the executor is faced with an IHT bill which can’t be paid because there is no cash available from the estate and the bulk of the estate’s value is held in property. The property can’t be sold even to pay debts, until the Grant of Probate has been issued.
The only way an executor can pay the IHT in these circumstances, is to pay the bill out of their own pocket and get repaid when the Grant of Probate has been received. The property, or part of it, can then be sold to pay back the money owed. If the executor doesn’t have the cash available to pay the IHT, there are only two options available. They could borrow the money on a loan and pay it back once the estate is sold. Most banks are willing to go for this option if they know that the property can be sold to pay the debt. The second option, if HMRC agrees, is to pay the IHT in instalments subject to interest.
Any way you look at it, this is not an ideal situation for the executor or beneficiaries of the estate.
By putting in place a Whole of Life policy written into trust, the deceased can ensure that funds become available to the executor or beneficiaries to pay the IHT liability and release the estate.
Many people can see the benefit of this, but baulk at the idea of using insurance to pay the IHT liability. The argument is that it is simply too expensive. While I understand this view and cannot pretend that Whole of Life Insurance is cheap, I think that the expense of a Whole of Life policy is overstated. To demostrate this I ran a quick quote for £400,000 of cover for a non-smoking 60 year old. The premiums would be approximately £8,500 per year (subject to underwriting), which is an expensive premium to fund. This is in fact more expensive than normal, as I would normally quote for joint life, which reduces the cost. When considering whether this expense is justifiable or not, it is important to remember that when you die you will receive £400,000 back, which will not be subject to IHT and will be rapidly available to pay any IHT liability. You would have to keep paying the premium for the next 48 years, in order to pay more into the policy than you get out.
Step 7: Review, review, review
Review the strategy annually to make provision for legislative changes and ensure that the plans remain suitable. This is a crucial part of the solution. There are regular legislative changes and many of the solutions also rely on investment. Ensuring that the solution remains valid and investments suitable is a key part of the process. This ensures that you are not caught out.
An example of such a change would be the new trust reporting rules that come into effect in 2021.
As you can see, we always start with the will as the foundation, with the rest being applied in a structured process to remove the excess assets and income from the scope of Inheritance Tax through gifting or utilising reliefs and eventually prepaying the remaining IHT liability using Insurance.
To help with this process, I have included a flow chart below. This is a useful decision tree that can help you ask the right questions to get you to a point where you have an idea as to which options might be suitable for your needs. However, it is only a guide. There may be personal circumstances or unforeseen legislation or rules that impact your situation that you are unaware of. This flow chart also cannot tell you if you might get a better result using several different solutions together. Therefore, it is always best to take some advice.
IHT and Estate Planning Flowchart: