Explaining estate planning and the nil rate band
article on IHT by Adam Benskin
This article has previously been published by The FTAdviser 04.05.17.
In 1986, Roy Jenkins, former Labour MP and Chancellor of the Exchequer, said that Inheritance Tax (IHT) is “a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue”.
Given the plethora of opportunities available to those seeking to reduce the IHT exposure on their estates, that would seem to remain the case. The purpose of this article is to provide an overview of the current IHT regime and consider some aspects of IHT planning.
IHT can be triggered when someone dies, but can also be triggered during their lifetime.
On death, IHT is charged on the value of a deceased’s worldwide estate if they are UK domiciled, or on their UK situs assets only if they are not deemed domiciled in the UK. The taxable estate includes property, possessions, money and investments, less any debts the deceased may have owed, such as mortgages, household bills and funeral expenses. Moreover, an estate also includes the value of any assets not owned directly, but in which the individual had a beneficial entitlement, such as life interests in trust property.
During life, a charge to IHT arises on non-relieved transfers into relevant property trusts, which, following an overhaul of the taxation of trusts in 2006, encompasses all trusts other than bare trusts and those for disabled people. Relevant property trusts are also subject to IHT, in the form of 10-year periodic and exit charges.
How IHT is calculated
Within 12 months of the date of death, the executors are required to submit an IHT account to HMRC (IHT400 plus schedules) confirming the gross value of the estate and the deductions/reliefs that are being claimed to determine the taxable value of the estate, which is then subject to IHT at 40 per cent.
The rate of tax on chargeable lifetime transfers is 20 per cent, while the periodic and exit charges applicable to relevant property trusts are up to 6 per cent of the trust assets.
HMRC may require independent valuations for some assets in an estate, such as valuable art, jewellery and property.
When it is payable
IHT must be paid six months after the end of the month in which the deceased died; otherwise HMRC will charge interest on the tax owed. In order for the assets of an estate to be distributed, a grant of representation is required and can only be obtained once the IHT liability has been settled.
Where an estate comprises land, buildings or unquoted shares that cannot be sold immediately, HMRC permits the IHT to be paid in annual instalments over up to 10 years or until the asset is sold (if sooner). Interest is charged on the outstanding tax liability.
For chargeable lifetime transfers, the tax is payable within six months of the month in which the transfer occurred, or by 30 April in the following year if the gift was made between 6 April and 30 September.
Who is responsible
Typically, the executors will pay IHT using funds from the deceased’s estate.
Trustees are usually responsible for paying IHT on trust assets, including chargeable lifetime transfers. However, if a donor decides to pay the tax on a chargeable lifetime transfer, the gift is grossed up by 1.25 before the IHT rate is applied to reflect the loss to the donor’s estate.
Where a donor has made a gift to an individual as a potentially exempt transfer and dies within seven years, the recipient is liable to pay any outstanding IHT in respect of the gift.
The main reliefs and exemptions that can serve to reduce, or even remove, a potential IHT liability are:
- The nil rate band (NRB)
- The residence nil rate band (RNRB)
The NRB is the value of an estate that is exempt from IHT. It has remained at £325,000 since 6 April 2009. Any unused NRB can be transferred to a surviving spouse or civil partner.
Since the NRB was frozen in 2009, the price of an average house in the UK has risen 38 per cent, the average value of homes in the south east has risen by 58 per cent, while in Greater London house prices have increased by 97 per cent.
Recognising that the growth in house prices was bringing more estates within the scope of IHT, former Chancellor George Osborne announced a new RNRB in the Summer Budget 2015, to be phased in from 6 April 2017. Like the NRB, the RNRB is transferable between spouses and civil partners on death.
The RNRB is available where the main residence passes to a direct descendant and the total value of the estate is below £2m. Where an estate exceeds £2m, tapered withdrawal will apply, meaning that for every £2 that the deceased’s net estate exceeds £2m, the RNRB will be reduced by £1. This means at outset there will be no RNRB for an estate with assets of more than £2.2m. The RNRB is set to increase on an annual basis until 2021, as follows:
Tax Year RNRB
From 2021, the RNRB will increase in line with the consumer prices index (CPI).
For a married couple with an estate valued at £1.5m, including a property valued at £1.0m, the introduction of the RNRB will reduce their potential IHT exposure from £340,000 (2016/17) to £200,000 (2020/21).
For those with high value estates, it may be worth taking advice to ensure that the RNRB can be used effectively on the first death to ensure the total value of the estate at the time of the second death does not exceed the £2m cap. If not, tapered withdrawal could see the value of RNRB being lost.
To the extent that an estate is valued in excess of the available IHT nil rate bands, there are various transfers that are exempt from IHT:
- An estate passing to a surviving spouse or civil partner is exempt from IHT (subject to any mismatch of domiciles).
- Lifetime gifts of up to £3,000 in any tax year are exempt from IHT, and any unused exemption can be carried forward one year. There are also small gift exemptions (up to £250 to any one person) and gifts in consideration of marriage/civil partnership. For example, each parent can give their child up to £5,000 when they are married, making the total £10,000.
- Gifts made to charities and political parties are exempt from IHT, as are some gifts of heritage assets. Where an individual bequeaths 10 per cent or more of their estate to charity, the IHT rate applicable to the remainder of their estate is reduced from 40 per cent to 36 per cent.
- Where gifts are made during a person’s lifetime out of surplus income, the value is exempt from IHT provided the donor can demonstrate that their standard of living was not adversely affected, the gift was made out of income (not capital) and that there is an intention to make regular gifts. It is possible to carry back up to two tax years for the purpose of claiming the exemption. Anyone wishing to rely on this exemption should maintain records of their income and expenditure, and the format HMRC requires is on page 6 of the IHT403 gifts and other transfers of value form.
Potentially exempt transfers (Pets)
Unless a gift is a chargeable lifetime transfer or exempt, it will be a Pet. No IHT is payable when a Pet is made, although if the donor dies within seven years, IHT is brought back into the charge. If death happens within three years, IHT is payable at the full rate, and then the tax liability is reduced by 20 per cent each year thereafter.
At its simplest, an estate planning strategy could involve someone giving away everything they own valued in excess of the nil rate band and then surviving for seven years. This is what Roy Jenkins meant when he said that IHT is a voluntary tax. However, as a consequence, the donor may end up trusting their heirs to provide them with financial support later on in life, which may be a far less appealing prospect than exposing their estate to IHT.
There are certain statutory IHT reliefs available for particular assets, such as business property relief, agricultural property relief and woodlands relief. Relief is available at either 100 per cent or 50 per cent. With some exceptions, the asset must be held for a minimum qualifying period of two years. For anyone wishing to reduce their exposure to IHT without making gifts, investing in assets that qualify for these reliefs, such as shares in unquoted trading companies or woodland, can be attractive.
Anyone contemplating IHT planning should consider their position if they do nothing, because any planning they engage in will not be for their personal benefit, and the planning is likely to incur costs, demands on their time and the need for decisions to be made. For some, doing nothing will result in a satisfactory outcome, even though tax may end up being paid.
For others, reducing the IHT exposure on their estates is an important objective to try to ensure the financial security of future generations. They might consider making gifts directly to their heirs, or using structures that allow them to retain some control over the amounts gifted, such as trusts or family investment companies. If gifts are not desirable, making investments that qualify for statutory reliefs can be attractive, subject to understanding the risk characteristics of the underlying assets. It is usually the case that a combination of gifts, use of exemptions and other planning will meets the needs of a particular situation, and that is where the skill of an adviser can add significant value.
This article is intended to provide a general overview of IHT and some of the planning that can be undertaken. It is not a comprehensive review of all of the options – other, more complex, strategies exist and no one solution is appropriate in all circumstances.
IHT can be triggered when someone dies, but can also be triggered during their lifetime.
For chargeable lifetime transfers, the tax is payable within six months of the month in which the transfer occurred.
George Osborne announced a new RNRB in the Summer Budget 2015.
Adam Benskin, CEO