In this second article on inheritance tax we take a look at some of the exemptions available and a brief look at a couple of planning options that can reduce an inheritance tax liability.
Some gifts are always inheritance tax free
The most well known is perhaps, that any gift between spouses or civil partners are free from inheritance tax.
There is also an annual gifting allowance of £3,000 every year. This is called the ‘annual exemption’.
If you don’t use your full £3,000 annual exemption in one year, you can ‘carry over’ the remainder and use it the following year.
Furthermore, you can make small gifts (up to £250) to as many different people as you like, but you cannot use your annual exemption and your small gift exemption on the same person in the same year.
Wedding gifts are also free from inheritance tax, provided you keep to certain limits. You can make a wedding gift of up to £5,000 for your child, up to £2,500 for your grandchild.
Inheritance tax will not be paid on gifts made to charities, national museums, universities, the National Trust, political parties and some other institutions such as housing associations.
Another approach is to use the “normal expenditure out of income” exemption. This is one of the more generous exemptions and can in many circumstances be more suitable than a single large outright gift.
In brief, to use this exemption you make (or start to make) a series of regular gifts out of your after tax income. If you can satisfy the conditions for the exemption the gifts are exempt from IHT as soon as they are made and you do not have to survive for seven years.
The exempt gifts do not cut into your nil rate band. If your circumstances change, you can stop making the gifts without losing the exempt status of those you have already made.
Other gifts may be subject to inheritance tax
These are usually called ‘potentially exempt transfers’. They typically become free from inheritance tax provided the person making the gift survives for seven years after the gift is made. If the person who made the gift dies within seven years, the value of the gift will be included in their estate. The person receiving the gift will have to pay any inheritance tax due.
It’s worth noting that the rate of inheritance tax due reduces if the person making the gift survives between three and seven years (known as ‘taper relief’).
However, as the nil-rate band is applied against gifts made in the last seven years first, taper relief will only help where gifts worth more than £325,000 have been given away in the seven years before death.
Time between making
gift and death Rate of taper relief
0–3 years No taper relief
3–4 years 20%
4–5 years 40%
5–6 years 60%
6–7 years 80%
After 7 years there is no inheritance tax due
You’re not required to keep details of the gifts you make while you are alive, but it’s extremely helpful if you do because after you pass away, the executors who deal with your estate will have to account for any gifts you made during the last fourteen years of your lifetime.
Setting up a trust
People usually set up trusts as a way to make sure assets are kept in the family over generations, with one the biggest advantages being that they can be set up
exactly to your own personal wishes.
There are several different types of trusts to meet different needs. For example:
- If you want to leave assets to children or grandchildren, but you don’t want them to have
access to the assets until they’re a certain age.
- If you want to place certain restrictions on how your estate is allocated to beneficiaries.
- If you want someone to receive an income from your assets during their life, but ultimately want the assets to be passed to someone else.
A trust can reduce your inheritance tax liability by transferring assets progressively out of your estate, with the liability reducing over a seven year period, In line with taper relief shown above.
A transfer out of your estate is considered to be either a chargeable lifetime transfer or potentially exempt transfer, depending on the type of trust chosen. The tax treatment for each is slightly different, either way, and regardless of whether you survive the seven-year period, a trust can significantly reduce your inheritance tax liability.
Taking out life insurance to pay inheritance tax
Most life insurance policies will form part of your taxable estate when you die, but if the policy is ‘written into trust’, any payouts from the policy after your death will be outside of your estate for inheritance tax purposes.
The beneficiaries of the trust are usually those people who inherit your estate, thus giving them the cash needed to pay the tax liability.
Taking out insurance doesn’t reduce the amount of inheritance tax due on an estate, it is simply another way to pay a potential inheritance tax bill.
Investments in Business Property Relief (BPR) -qualifying companies
BPR was introduced as part of the 1976 Finance Act, and it was created to allow small businesses to be passed down through generations without facing a large inheritance tax bill.
Whereas making a gift or putting assets in trust means they take seven years before they become exempt from inheritance tax, shares in a BPR-qualifying company or investment become exempt from inheritance tax after being held for just two years, provided the shares are still held at the time of death.
Thus, using this as a planning option can bring faster relief from an inheritance tax liability.
The value of a BPR-qualifying investment portfolio will depend on the performance of the companies it invests in and it is important to note that investments in AIM-listed and unquoted companies are likely to fall or rise in value more than shares listed on the main market of the London Stock Exchange and that they may also be harder to sell.
Combined with my first article looking at inheritance tax basics, you hopefully have some useful information from which you can further explore the best solution to your potential inheritance tax liability.