What is Inheritance Tax?
Inheritance Tax (IHT) was once only a worry for the rich and famous. But this is no longer the case, as rising asset values and static thresholds drag more and more families into its widening act.
IHT is, essentially, a tax levied on any transfer of assets to other people or trusts. It is typically paid in respect of the value of your estate on death, but it can also apply in respect of certain transfers of assets during your life.
IHT is calculated on the value of an ‘estate’ which is defined as the property, money and possessions that are left for beneficiaries. The assets which form part of an estate include:
- Cash in a bank
- Jewellery, art, antiques and home furnishings
- Any property or business
- Payouts from life insurance policies
IHT is only payable if the value of the estate exceeds £325,000, and this is known as the Nil-Rate Band (NRB). If someone is married or in a civil partnership, then they have a combined NRB of £650,000.
The NRB can also be extended through use of the Residence Nil-Rate Band (RNRB) which was introduced in 2017. This enables a further £175,000 of relief to be available if the qualifying conditions are met.
Unless other reliefs or exemptions apply, 40% IHT is payable on estates which are valued over the relevant threshold.
If you die when ‘domiciled’ or ‘deemed domiciled’ in the UK, then IHT applies to all of your assets wherever they are situated.
Domicile is a technical concept which identifies your permanent home. If you died domiciled abroad, then IHT only applies to assets situated in the UK.
Under current legislation, IHT can be perceived as a voluntary tax. This is because with careful planning, it is possible to reduce or remove any liability altogether.
Inheritance Tax facts
- IHT receipts received by HMRC during the financial year 2021 to 2022 were £6.1 billion, a 14% increase on the year prior.
- An increasing number of families’ estates are liable to IHT, principally because of rising house prices.
- IHT is considered by some to be a ‘voluntary tax’ which can be mitigated with sound financial planning.
- It is easy for people to make costly mistakes, so we recommend you seek IHT planning advice.
- Stellar Asset Management has the expertise to work with people and their advisers, to determine the best approach to mitigating IHT.
Simple worked example
On an estate which is worth £500,000, IHT would usually be charged on £175,000 – which is the total estate value minus the standard NRB of £325,000.
The calculation would be £175,000 x 40% = £70,000 to pay in IHT. This means that only £430,000 would be inherited.
However, if the £175,000 has been invested with Stellar Asset Management for the previous two years or more, it would qualify for Business Relief – and no IHT would be payable. Capital is at risk and returns are not guaranteed.
What is the Residential Nil-Rate Band (RNRB)?
Legislation offers qualifying estates an additional RNRB of up to £175,000. This additional allowance was phased in over four years:
- £100,000 to 5 April 2018
- £125,000 to 5 April 2019
- £150,000 to 5 April 2020
- £175,000 to 5 April 2021
There are limitations on which estates are entitled to this additional threshold and the relief is tapered for estates valued at over £2 million.
Will you have an Inheritance Tax liability?
IHT is payable on the transfer of chargeable property which, after deduction of liabilities, exemptions and tax relief, exceeds the nil-rate band.
Who pays Inheritance Tax?
- Domiciled individuals.
- Deemed domiciled individuals – resident in the UK in 15 out of previous 20 tax years.
- UK residents.
Non-domiciled individuals are liable on their UK assets only.
This is the value of your worldwide assets (for domiciled individuals) that you transfer to other individuals or trusts and that you leave in your estate when you die. However, if the transfer is made to your spouse or registered civil partner, it will be exempt from IHT. This only applies if you and your spouse or partner is UK domiciled.
There are certain liabilities which can be deducted from the value of an ‘estate’. These liabilities are typically reasonable funeral expenses, mortgages, outstanding loans and other debts.
Exempt transfers are those which can be made without a tax liability. The most important include:
- Spouse exemption – transfers between spouses and registered civil partners whether during life or on death.
- Charities – Gifts and bequests to a charity that is a UK registered charity or other qualifying body (such as hospices and orphanages).
- National Benefit – Gifts and bequests to certain national institutions.
- Political Parties – A transfer of value to a qualifying political party.
- Housing Associations – transfers to a registered social landlords.
- Family Maintenance – Payments made in favour of dependent relatives that make reasonable provision for their care or maintenance.
Certain assets can obtain relief from IHT. The most important include:
If you own a business, then you can get 100% relief from IHT if it meets various conditions.
If you own certain assets that you use in your business, you may be able to get 50% IHT relief.
The eligible assets, and the rate of tax relief, are as follows:
- A business or interest in a business – 100%
- An interest in a business partnership – 100%
- A holding of shares in an unlisted company – 100%
- A controlling interest in a listed company (more than 50% of the voting rights) –50%
- Land, buildings or plant and machinery used in your business and held in trust that you have the right to benefit from – 50%
Business property does not qualify for the relief unless you have owned it for at least two years.
Shares in an unlisted company include companies quoted on AiM (Alternative Investment Market).
Business Relief will not be available if the business is engaged wholly or mainly in dealing in securities, stocks or shares, land or buildings, or is an investment company. If there is a binding contract for sale, such as a ‘buy and sell’ agreement, relief is also not available.
Agricultural Property Relief
If you own a farm, then you can get 100% relief from IHT, if it meets various conditions. These are that:
- You have the right to vacant possession of the property or the right to obtain it within the next twelve months, or
- The land is let on a short-term grazing licence, or
- The property is let on a tenancy beginning on or after 1 September 1995.
In addition, you must have occupied the property for at least two years or, alternatively, if the property is occupied by someone else, owned the property for seven years. Throughout these periods, the property has to have been used for agricultural purposes. The agricultural property must be located in the UK, Channel Islands, Isle of Man or European Economic Area and includes:
- Farmhouses, cottages or buildings, which are of a character appropriate to the property
- Woodlands and buildings used for livestock
- Growing crops included with the land
- Stud farms engaged in the breeding and rearing of horses
- Land and buildings used in the cultivation of short rotation coppice
- Any land within a habitat scheme
Please note that if the farm buildings have a lifestyle value, for example a farm cottage could be sold as a second home, that additional value will not attract Agricultural Property Relief.
How to mitigate Inheritance Tax
Taking advantage of the lifetime gifts provisions may not be enough and a substantial potential tax liability could remain. However, there are still steps that can be taken to mitigate a potential IHT liability.
One of the simplest methods of reducing the value of a taxable estate is to give away surplus cash and assets, then to survive for a period of seven years. This can be to individuals or to a trust arrangement.
It must be an outright gift to be effective; for example, the gift of a house subject to continuing occupation at less than a commercial rent is likely to be ineffective. When a gift is made to an individual it will normally be exempt or a potentially exempt transfer. One category of lifetime gift that can be subject to an immediate IHT charge is a gift into a trust.
Examples of exempt lifetime gifts, include:
- Annual exemption – lifetime transfers of up to £3,000 each tax year are exempt from IHT. If the whole of the £3,000 is not used in any tax year, the balance can be carried forward to the next tax year.
- Small gifts exemption – outright gifts of up to £250 in any one tax year to any number of people are exempt from IHT.
- Normal expenditure out of income – lifetime gifts which are of a regular nature, and made from net income, qualify for an exemption if they do not affect your normal standard of living.
- Marriage gifts exemption – gifts made by certain people in consideration of a marriage or a civil partnership taking place are exempt: from a parent: £5,000, from a grandparent: £2,500 and from others: £1,000.
- Exempt transfers. Any gifts or bequests in favour of ‘exempt’ beneficiaries are free of IHT. For example, a gift in favour of a surviving spouse or a charity is exempt from tax.
- The nil-rate band. The law of IHT allows an individual to transfer as much as they like to a UK domiciled spouse or registered civil partner, without liability and, with effect from October 2007, any of their unused nil-rate band.
- Will Trusts. It is possible for you to include a discretionary trust in your will on death. You could use this to hold any business or agricultural property, thereby using the 100% relief available.
Use of trusts
There are a number of trusts which can be used, the suitability depending on the precise requirements of the individual and the tax consequences of the trust. One of the reasons for establishing a lifetime trust is to provide for minor children who are too young to take legal responsibility for gifted assets.
Lifetime gifts into trusts are generally chargeable lifetime transfers.
Types of trust
- Bare trust. A bare trust is one under which the beneficiary is absolutely entitled to benefits (both income and capital). At age 18, a beneficiary, who is absolutely entitled, can call for their share of the trust fund to be paid to him or her.
- Interest in Possession Trust. A trust where one beneficiary is entitled to the trust income as it is generated, and the interest usually passes on the death of the life tenant to other beneficiaries.
- Discretionary trust. A trust where a list of named beneficiaries, or categories of beneficiary, are entitled to the trust fund. The trustees have the discretion to appoint capital and income to any beneficiary or beneficiaries. It is important that the person creating the trust reserves no benefit from it or there may be adverse tax consequences.
- Discretionary Will Trusts. If the will trust is discretionary in nature, the surviving spouse, children and grandchildren can be beneficiaries. The trustees can decide who should benefit from income and capital and can make appropriate payments. So, for example, capital or income could be appointed to the surviving spouse as and when required leaving the rest of the trust intact for distribution to children or grandchildren after the surviving spouse’s death.
Chargeable lifetime transfers (CLTs)
These are transfers which are neither exempt, nor potentially exempt. The most common chargeable transfers are lifetime gifts into certain types of trusts. A transfer will be chargeable if it (together with any transfers made in the previous seven years) exceeds the nil-rate band.
Tax is payable at 20% on the excess over the nil-rate band and the transfer will not be included in the estate on death if the person survives for seven years. If death occurs within seven years, then tax at death rates will apply to the transfer retrospectively. Credit will be given for the tax already paid.
In addition to the tax charge on creation of the trust, a ten yearly periodic charge is raised at 6%. This tax rate is applied to the amount by which the trust fund exceeds the nil-rate band at that time. A proportion of this tax will be payable on distributions from the trust during a ten-yearly period.
Reservation of benefit
Any attempt by the person making the gift to reserve a benefit is likely to invalidate the original gift. Examples include a gift of shares, while retaining the right to dividend income, or the gift of a house subject to a right of rent free occupation. Where the person making the gift reserves a benefit for himself, then the value of the property in question at the date of death will be included in the deceased’s estate for IHT purposes.
Pre-owned assets tax (POAT)
POAT was introduced in 2004 as an anti-avoidance measure, designed to curtail the use of certain IHT planning arrangements. There is an income tax charge on the benefits received by the former owners of property, which they had transferred to certain arrangements.
Potentially exempt transfers (PETs)
This is a term which describes gifts of cash and assets which, subject to certain conditions, will not incur a liability to IHT. Specifically, gifts between individuals are termed PETs.
A PET made more than seven years before death becomes an exempt transfer. If death occurs within seven years, then the gift becomes taxable, subject to any taper relief and the nil-rate band. Taper relief is a reduction in any tax payable in respect of the gift, which effectively increases from 20% after three years to 100% after seven years.
Investment based solutions
Investment bonds are commonly used in IHT mitigation arrangements, and they can be obtained from UK life offices or from offices based in offshore jurisdictions. The choice of asset does not affect the IHT position but may affect the settlor’s income tax or capital gains tax position as well as the eventual amount received by the beneficiaries.
Single premium bonds
A capital sum could be invested, with the policy written under trust for the beneficiaries of an estate.
Discounted gift trusts
This is an arrangement using a single premium investment bond and a specially drawn up discretionary trust. This allows an individual to make substantial gifts into a trust but retain the right to receive a chosen level of payments during his or her lifetime.
If the individual dies within seven years, the value of the gift for IHT purposes may be reduced because of the retained right to income payments. Therefore, only the discounted value would be included in the calculation of inheritance tax payable. After seven years the residual fund will be outside of the individual’s estate. Growth on the investment will normally be outside of the individual’s estate.
Gift and loan schemes
These are designed to couple IHT savings with full access to capital. The investor establishes a trust for, say, £10, for his prospective beneficiaries. He then makes a significant loan to the trustees, expressed to be interest free, repayable on demand. The trustees invest this in a single premium bond, then take annual part withdrawals and pay these to the investor in repayment of the loan. These will typically be set at 5% pa, repayable on demand.
The advantages of this type of scheme include:
- An initial gift which will usually be covered by the investor’s annual IHT exemption
- Any growth in the investment is outside of the investor’s estate for IHT purposes
- A reduction in the value of the investor’s estate over 20 years, assuming that the loan repayments are spent as income
The principal disadvantage of this type of scheme is that IHT savings take place over a 20-year period.
Insurance based solutions
Life assurance can play a role in either meeting or reducing a prospective IHT liability. Whole of life assurance is the oldest established, and arguably the most effective method of meeting an IHT bill. As the date of death is uncertain, a whole of life policy is effected to ensure that capital is available at death to meet the IHT bill.
Policies are normally written under a suitable trust arrangement to ensure that the policy proceeds do not comprise the deceased’s estate on death. Premium payments may be treated as CLTs, unless covered by the annual or normal expenditure out of income exemptions.
If you want to know more about the wide range of innovative estate planning solutions available, either:
Email us at firstname.lastname@example.org
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This guide is based on Stellar Asset Management Limited’s understanding of applicable legislation, law and current HM Revenue & Customs practice. It is provided solely for general consideration.
The information regarding taxation is based on our understanding of current legislation, which may be altered and depends upon the individual financial circumstances of the investor.