The most straightforward way of reducing your potential inheritance tax liability is making lifetime gifts. Although the principle is simple in itself, though, there are a number of booby traps out there. On the principle of “forewarned is forearmed”, we thought it would be a good idea to have a look at some of these.
A Simple Tax
The basic idea of inheritance tax is certainly fairly simple in itself. Everything you are possessed of when you die gets valued, and tax is chargeable on it at 40%: subject to some important reliefs. Probably the most important of these is the “spouse exemption” (which also applies to civil partners), under which everything left in your will to your surviving spouse or civil partner, or to a trust in which they have a “life interest”, is exempt. You can mitigate your exposure to inheritance tax by making lifetime gifts, but if you die within seven years of any of these, they are brought back into charge: subject to a 20% “taper” for each year after the third. The big issue in inheritance tax planning is to decide how much, if anything, you can afford to give away and keep the financial security that you need in your advancing years. But as well as this crucial problem, there are also technical problems with making lifetime gifts, and traps you can fall into if you’re not careful. A lifetime gift is called a “potentially exempt transfer” or PET, because, providing you breast the seven year tape after making the gift, it will be treated as an exempt transfer.
Problem Number One: Not Enough Tax Paid on the PET
This feature of IHT is very often misunderstood. The tapering after year 3 from the gift is of the tax which applies to that gift, and not to the value of the gift itself. Let’s have a look at an example.
Barnaby has assets worth £1 million, on which he (or rather his children) are looking down the barrel of a potential inheritance tax bill of £270,000. This is worked out as the £1 million less the inheritance tax “nil band” of £325,000. (Barnaby is only entitled to one nil band.) Barnaby is certainly getting on in years, and is none too well, but he reckons that, even if he doesn’t manage another seven years in this vale of tears, he should be able to manage three, or possibly even four or five. (Inheritance tax forces one into these unpleasant and macabre calculations.) Whilst Barnaby can’t afford to give his whole estate away, he does reckon that he can do without £400,000 of his million, so he gifts this equally to his two children, hoping thereby, if all goes as well as it can, to save £160,000 in inheritance tax, and thus make a real dent in the potential liability.
In the event, Barnaby dies just over four years after the gift, and therefore the taper relief applicable is 40%. But here’s the rub. The PET is counted first in calculating his tax, and therefore has the whole of his nil band offset against it. Only £75,000 of the gift comes back into tax, with the whole of the rest of Barnaby’s estate being fully taxable. The tax on £75,000 of the gift is £30,000, and it is this £30,000 which is tapered by 40%. So the gift, instead of saving £160,000 as Barnaby had hoped, saves only £12,000.
The moral of this, if there is one, is to make PET’s of a much more substantial amount if you possibly can, and if you think you may be struggling to carry on in this life for as much as seven years. Alternatively, simply be aware of this rule and, if appropriate and possible, take out life insurance for the maximum potential tax in the light of this harsh rule.
Problem Number Two: Lifetime Gifts which Increase the Tax
Strange to say, the worst-case scenario with PET’s that don’t work, because someone dies too soon, can actually leave you in a worse situation than if you hadn’t made the gift at all. Let’s look at a case of how this can happen.
Doug and Heather are a very old couple, and unsurprisingly therefore, they are also old fashioned. Money matters have always been dealt with exclusively by Doug, who was the (well paid) breadwinner of the couple. He has also kept complete control of the purse strings, and Heather has very little in the way of savings, and no income apart from her state pension. So when they decide (or rather Doug decides) that the time has come to plan for inheritance tax, and make a gift to their only child Susan, the gift naturally comes out of Doug’s resources.
Unfortunately they are conventional in another respect too. Doug is quite a bit older than Heather, and, being a man, has a lower life expectancy. As it turns out, he dies less than three years after making the gift to Susan, and, even though he has left a will in which everything goes to Heather, there is still tax to pay on his death, being 40% of the excess of the value of the gift over his £325,000 nil band. If Doug hadn’t made the gift at all, there would have been no tax payable on his death, because the whole lot would have gone to Heather and been exempt from tax.
It’s true to say that retaining the money in the above example, rather than giving it to the child, would have effectively passed the problem on to Heather: but it might well have been that she would have been able to make the gift and survive seven years from doing so. Moral: always consider, in the case of couple, who makes the gift. It makes obvious sense for this to come from the person who is more likely to survive seven years. This leads us on to the closely allied Problem Number Three.
Problem Number Three: The “Healthy” Spouse Should have Made the Gift
Polly and Digory decide to make a gift to their only child, Eustace, so that he can get on the property ladder. So they transfer to him £200,000 out of their joint savings account, to act as the deposit for a flat in London. What they should have take into account is the fact that Digory has prostate cancer, which, unexpectedly, becomes “live” and spreads to the rest of him, killing him within two years of the gift to Eustace. Half of the £200,000 gift is treated as made by him, because it came out of a joint savings account. And so £100,000 is added back to Digory’s estate and becomes potentially taxable.
Of course, in the above example, the question of whether this creates a tax charge depends on the terms of Digory’s will, and all would be well if he happens to have left his entire estate to his widow Polly. But any such potential tax charge could have been avoided by considering the life chances of the couple. It would have been possible, no doubt, for Polly to have been the source of the whole £200,000 gift.
This brings us on to an interesting question to which there isn’t a very clear answer. What if Digory had simply transferred the money from their joint account to Polly’s sole account before the gift was made? Can we get out of Problem Number Three as easily as that?
Our views on this are it would be dangerous, because HMRC could conceivably argue that routing the money through Polly’s account hasn’t actually changed the essential nature of the gift as being a joint one originating from both of the couple.
Problem Number Four: Forgotten Trusts
Since 2006 all lifetime gifts to trusts have been chargeable to inheritance tax, at the “lifetime rate” of 20%, to the extent that they exceed the nil band of £325,000. For this purpose you add up all gifts of this sort made in the last seven years so that if, for example, £300,000 was put on trust five years ago, and another £100,000 now, £75,000 of the current gift would be chargeable. This is the one real exception to the rule that inheritance tax only applies on death. The problem is, people don’t always remember this seven year accumulation rule.
Peter decides to set up a trust for his children, and puts £325,000 into the trust. It just so happens that HMRC become aware of this trust and start asking questions. It turns out that, six years ago, Peter wrote an endowment policy of life insurance in trust for his children, on the advice of an independent financial adviser. The idea was that he would continue to make premiums, but the value of the trust would be outside his estate. The problem was that the endowment policy had a value already at the time, of £300,000. So, although this was something of a obscure point, to put it mildly, £300,000 of the gift now made into trust exceeds his available nil band and is chargeable to tax at 20%, hitting Peter’s pocket book to the tune of £60,000 inheritance tax.
One of the morals to be derived from this story is to remember that what looks like boring paperwork put in front of you by an IFA for signature could turn out in fact to be a fully chargeable trust transaction.
Problem Number Five: Increasing Capital Gains Tax – Without Reducing IHT
We highlight this situation because it’s counterintuitive. One would naturally consider that making gifts of businesses (for example shares in the family trading company) is a good thing to do. But it can backfire in a spectacular manner, not so much with increased inheritance tax liabilities, but with increased capital gains tax. Once again, it’s easier to illustrate the point by taking a hypothetical example.
Frank is proud of how he has built up the family business, Turnstile Limited, from nothing in 1982 to a multimillion-pound business now. He owns 100% of the shares, even though his son Stuart is now firmly in charge, with the office, the big desk and the parking space marked “Managing Director”. The company manufactures turnstiles for sports grounds, and is wholly trading in nature.
Bowing to pressure from Stuart, Frank finally summands the resolution to make a gift of the shares to him. This is where tax advice obviously comes in, and he asks his accountant, who informs him that, whilst the gift of the shares is treated prima facie as if it were a sale of those shares for the current market value (which is £10 million) this “gain” can be “held over” by way of a joint election by Frank and Stuart. So for capital gains tax purposes Stuart takes over the shares, effectively, at their 1982 value which is the square root of not very much.
As it happens, Frank dies shortly afterwards, and the PET, ie the gift of the shares to Stuart, becomes in theory chargeable to inheritance tax. We say “in theory”, because, being a 100% trading company, the shares are fortunately eligible for 100% business property relief. So no tax falls due. In fact, this isn’t an inheritance tax disaster at all, but it does turn out to be a capital gains tax disaster. Mark the sequel.
Not long after Frank death, Stuart receives an offer he can’t refuse, of £12 million, for the shares in Turnstile Limited from a major sports manufacturer. When his accountant does the figures, Stuart finds that effectively the whole of the £12 million sale proceeds are chargeable as a capital gain, because he has only Frank’s original 1982 cost to offset. So the tax on sale, with the benefit of the paltry new “business asset disposal relief” is £2.3 million. If Frank had simply held on to the shares and left them to Stuart in his will, Stuart would have had “probate value” of say £10 million to offset as the CGT base cost: and the tax instead of being £2.3 million, would have been no more than about £400,000.
The moral of this is that – call it paradoxical if you like – it can be much better from the tax point of view for the older generation to hold on to assets which qualify for business property relief, such as shares in unquoted trading companies, interests in trading partnerships etc, than to pass these down to the younger generation.
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