INHERITANCE TAX IN THE UK

Inheritance tax is an important consideration when it comes to drafting wills. Inheritance tax is largely an avoidable tax in England and Wales but it can only be avoided if proper care and consideration is taken in drafting the will.

The tax itself is not payable up to a certain exempt amount but thereafter the rate on death is 40%. Currently the first £242,000 is exempt from inheritance tax. Any transfer in excess of this amount which takes place either at death or within seven years of death is taxed at 40%. When the value of a house is taken into account it is not so unusual for an estate to exceed the exempt amount.

You will be charged to inheritance tax in the UK in the following circumstances:

(a) If you are UK domiciled, the tax applies to all your assets worldwide.

(b) If you are not UK domiciled then only your UK property is liable.

However:
(i) If you have been resident in the UK after 9 December 1974 and UK resident in at least 17 of the 20 tax years (or periods) up to and including the year of the transfer or death, or

(ii) If you were UK domiciled after 9 December 1974 and within three years before the transfer or death then you will be deemed UK domiciled and taxed accordingly.

The seven-year rule on gifts.

The easiest way to avoid paying inheritance tax is yo use your annual tax free exemptions and give your money away during your lifetime. There is no liability to Inheritance Tax on lifetime transfers as long as the donor lives for a further seven years after which time the value of the gift would be completely out of his/her estate. However, if you die within seven years of making a gift, and you are leaving over £242,000 (including taxable gifts given in the last seven years), your estate will be liable for some tax on the value (reduced in value by taper relief but still potentially taxable).

The Inland Revenue uses the following scale:

Years between gift & death Percentage of tax payable
Up to 3 years 100%
3 - 4 years 80%
4 - 5 years 60%
5 - 6 years 40%
6 - 7 years 20%
More than 7 years 0

Inheritance tax planning.

By the use of inheritance tax planning you can ensure that all your estate passes on to your children and grandchildren without being subject to the Inland Revenue taking a large slice first.
Early action is recommended.

Many gifts are exempt from tax, however, some are only exempt if they are made in your lifetime.
The lifetime (only) exemptions are:

(a) Small gifts up to the value of £250 can be given to any number of persons in any tax year provided that the person receiving the gift is not the same person or people as the ones who are getting the £3,000; these small gifts don't count in running up the £3,000 total. So, if you can afford to you should use up your tax exemptions each year and make as many small gifts as you can.

(b) Marriage gifts made by a parent (up to £5,000), a grandparent (£2,500), the bride and
groom to each other (£2,500), anyone else (£1,000) are exempt from tax.

(c) Normal expenditure made out of income. The gifts must be regular, usually of cash and must not reduce your normal standard of living e.g. an insurance premium.

(d) Dividends or remuneration waived for example by a director of a family owned company.

(e) Capital transfers for family maintenance e.g. after a divorce or for a dependant relative.

(f) Annual transfers up to £3,000 per annum are exempt from tax provided that the transfer totals no more than £3,000 per year. There is a one-year carry forward on this one, so if you don't give away £3,000 one year you can give away up to £6,000 the next, but you can't carry forward the unused £3,000 forward further than that. So, if you can afford to you should make sure to transfer £3,000 per year so as to avoid taxation in the long term. Larger gifts are tax free providing you live for 7 years or more following the gift and do not continue to derive any benefit from the assets given away

(g) Gifts between husband and wife are also exempt from inheritance tax provided that the donee spouse is UK domiciled. If not then the transfer is exempt only up to £55,000.

(h) Gifts to UK charities or to charitable trusts are generally exempt from tax.

(i) Gifts for "national" purposes including to certain recognised political parties, of land to registered housing associations, for national purposes (e.g. to a National Gallery) and for certain heritage property.

Are business assets exempt?

Some business assets and certain farming activities qualify for relief of 100% so in effect they are exempt. However, the exemption does not apply to land and buildings let out on rental. A lower 50% rate may be available if for example you own land and let your business trade from it. The rules concerning business and agricultural property relief are complex so take expert advice.

Insurance Policies.

Take out a life insurance policy in a trust for your children or grandchildren. Providing you can pay the premiums out of income - and don't have to dip into your capital to do it - this will come under the 'normal expenditure out of income' category. You have to 'assign' the policy to trustees so that it doesn't come into your estate when you die. If the policy is not assigned, the inheritance tax problem would be compounded because the estate, and therefore the tax bill, would be larger.

If you don't want to give your money away while you're alive, or you worry about not living for the necessary seven years after you've made gifts, then you can take out some insurance, in the form of a decreasing term insurance. To cover the potential inheritance tax bill that will be due on your estate, you will need a whole life policy. If you are a couple, take out a joint-life, second death policy. It will pay out on the death of the last survivor, and is cheaper than taking out two separate policies.

Inheritance Tax Planning for Married Couples.

One of the main areas of exemption is gifts between husband and wife, which is normally unlimited. It is this area which requires attention in most cases, as between them, a husband and wife have an exemption of up to £484,000 but often the appropriate planning has not been put in place.

A simple solution to save tax of £96,800 would have been for the husband to leave the £242,000 of his estate directly to his children and not to his wife. When the husband dies his children will receive £242,000 tax free. Then when his wife dies the children will receive a further £242,000 making a total of £484,000 tax free.

An Effective Solution

Could be for each spouse to draw up a will instructing that an amount up to the then current nil rate band be left in trust when he/she dies. The trust would be created by the will and should be a Discretionary Trust. The potential beneficiaries of the trust should be the surviving spouse and the children, but with the appointment of benefit left to the discretion of the Trustees.

The key here is to make the surviving spouse the Sole Trustee of the trust. This means that he/she can choose who benefits from the trust and has complete control of its assets. He/she may decide that he/she needs some or all of the assets and may make an appointment of benefit to himself/herself. Alternatively, he/she may appoint all the assets to his/her children

If the surviving spouse has need of the trust fund, it would make sense for him/her to arrange to take an INTEREST FREE LOAN from the trust which is REPAYABLE ON DEMAND. This would provide the required use of the trust assets but would also create a DEBT against his/her estate. As trustee, he/she can ensure the debt is not called in during his/her lifetime.

On his/her death, the loan is repaid to the trust and then appointed to their children tax free, as it falls under the nil rate band exemption of the first spouse to die. The estate of the second spouse to die is reduced by the debt and the balance is passed to the children tax free if it falls within his/her nil rate band exemption.
Eg.

Husband dies Leaves £242,000 in Trust with wife as sole trustee.

Trust loans wife - Wife has use of capital of £484,000.

Wife dies - Loan repaid to trust - Children receive trust proceeds plus mother's estate potentially Tax free.

Result: Children receive £484,000 tax free BUT having allowed wife to have access and control of husband's capital during her lifetime.

Jointly Held Assets

If your property and investments are held in joint names, they will automatically pass to the surviving spouse and are not governed by your will. They could not, therefore, pass into a will trust and would simply be added to the estate of the surviving spouse. It may be possible to avoid this by changing the ownership of the assets. Most couples who own their domestic property do so as "joint tenants". This means that the share of the first to die will pass automatically to the survivor. If the basis of ownership were changed to "tenants in common" it would mean that on first death, the deceased's share of the property could be transferred into the discretionary trust with the surviving spouse retaining the ownership of his/her share only but also control of the deceased's share of the property as trustee.

However, this strategy has potential pitfalls. If the deceased has left his/her share of the property to trustees and the other tenant in common is a potential beneficiary of the trust, it is open to question whether, in fact the surviving tenant in common has received a benefit from the trust if their sole occupancy continues, thereby possibly creating an interest in possession. This would enable the Revenue' to deem that the deceased's share of the property had passed into the estate of the surviving spouse for Inheritance Tax purposes and would remove any tax planning benefit.

If, on the other hand, the surviving tenant is excluded from any benefit under the trust, the trustees may be open to a charge that they have failed to do their best for the actual beneficiaries of the trust if they continue to allow the surviving tenant in common to occupy the property exclusively, asking no commercial rent, for example, in respect of the trust's share of property.

In any event, the Inland Revenue is increasingly hostile to the use of the matrimonial home for Inheritance Tax planning, and this makes the whole subject potentially risky for planning purposes. Any implications of an interest in possession in the whole property may be used as grounds for charging Inheritance Tax on the whole property by the Inland Revenue. Control of the property may be compromised by the conflicting interests of a younger generation, now able to force the surviving tenant in common out of the property and into alternative accommodation. There will be a loss of capital gains tax principal private residence relief on the half of the property acquired by a new, non-occupying, owner and a liability to CGT will therefore start to accrue from the date of the first death.

This information is based on our understanding of current tax law and Inland Revenue practice which may be subject to change in the future.