Inheritance Tax (IHT) is a tax on the estate (the property, money and possessions) of someone who’s died.
IHT on death
When an individual dies, all assets and liabilities (including reasonable funeral costs, taxes other than IHT etc) are valued at the date of death (Probate Value) and the net estate is charged to IHT at 40% after any allowances and exemptions.
The probate value then becomes the recipient’s base cost for Capital Gains Tax on later disposal.
Assets transferred to a UK domiciled spouse are exempt from IHT. Note that a non-UK domiciled spouse may only receive £325k free of IHT (on top of the nil rate band – see below) unless they elect to be treated as UK domiciled for IHT purposes. This is linked to the nil rate band, so when one increases so will the other, effectively doubling the nil rate band.
This means that when one spouse dies holding an asset with a large capital gain, they can pass it free of all tax to their spouse on death at current market value. This is often referred to as the “free Capital Gains Tax Uplift on death” The surviving spouse may then gift the asset on to say their children or grandchildren free of Capital Gains Tax. This may then become a potentially exempt transfer (“PET”) – see later.
Nil Rate Band (“NRB”)
The Nil Rate Band is an individual allowance which is deducted from your estate before charging IHT. Currently, then NRB is £325k. It is also now possible to inherit a spouses NRB where their assets are left to the surviving spouses, giving a NRB of up to £650k. Where the surviving spouse does not inherit the whole estate, then the proportion of NRB is transferred and uprated to the then rate:
George dies in October 1996 with a chargeable estate of £300k. He leaves £100k to his children and the rest to his wife, Mable. The Nil Rate Band is £200k, and thus 50% is unused and transferable to Mable.
In November 2017, Mable dies. She has a Nil Rate Band of £325k x 1.5 = £487,500.
Residence Nil Rate Band (“RNRB”)
The RNRB is an extra allowance which is available to assist in passing the family home down the generations.
This is available to individuals who die on or after 6th April 2017 with estate under £2M and pass the home to direct lineal descendants (i.e. children, grandchildren etc – including adopted/fostered children). It is worth a maximum (per individual) of:
2020/21: £175k, with CPI inflationary increases from 2021/22 onwards
Note that if the property is worth less than the RNRB, then this lesser limit applies. EG death in 2020/21 leaving a property of £100k and other assets of £400k. NRB £325k, RNRB £100k, taxable £75k @ 40% = £30k IHT.
For estates worth more than £2M, the extra relief is tapered away at the rate of £1 for every £2 by which the estate exceeds £2M.
Like the NRB, this can be transferred to a surviving spouse to be doubled up on the second spouse’s death.
Finally, where someone downsizes, or disposes of their residence (e.g. to move into a care home), the RNRB will generally still be available on the assets which have been generated from the downsizing/disposal.
Lifetime gifts made absolutely (i.e. directly to an individual rather than into a trust) are free of IHT at the time of gift, but remain chargeable within the donor’s estate for 7 years, and so are called Potentially Exempt Transfers (PETs).
Some transfers are immediately exempt:
- Small gifts up to £250 per person per tax year
- Gifts for wedding/civil partnership up to £1,000 per individual (or £5,000 for your own child, or £2,500 for grandchild or later generation)
- Ordinary gifts out of income – a much underutilised and limitless exemption (depending on income and normal expenditure)which does require good record keeping)
- Annual exemption – first £3,000 per tax year not covered by the above. Can also utilise last year’s if not already used (but must use current year’s first – i.e. £4k gift is £3k for this year and £1k for last year)
- Gifts to charity/political parties (with at least 1 MP) are immediately exempt
Otherwise, gifts fall into the PET regime. The value of the gift remains in the estate for the full 7 years, but the rate of the tax reduces after three years and annually thereafter:
0-3 yrs: 40% tax
3-4 yrs: 32% tax
4-5 yrs: 24% tax
5-6 yrs: 16% tax
6-7 yrs 8% tax
> 7 yrs: nil
Gifts made into discretionary trusts are not PETS but Chargeable Lifetime Transfers (CLTs) and, if in excess of the nil rate band, some lifetime IHT may become payable. The scope of these complex trust rules is beyond this briefing note.
Note that outright gifts, whilst potentially advantageous from an IHT perspective, will be treated for Capital Gains Tax (CGT) as a disposal and CGT charged as if market value proceeds were received. This is often a difficulty in IHT planning, as you may pay 28% now to try and save 40% in the future, with the risk of paying both if you do not survive 7 years.
Where the gift is of qualifying business assets, or is a CLT into a trust, it is possible for the donor and donee to make a joint holdover election, meaning that the donee takes over the donor’s base cost rather than present market value as their CGT base cost.
Business Property Relief/Agricultural Property Relief on own business (not excepted assets such as investments held in the company) and also unquoted/AIM listed BPR etc investments. Note replacement assets rules may apply for individuals who say sell their personal company shares then invest proceeds into BPR qualifying investments such as EIS funds.
Legacies to charities/political parties (note reduction in IHT rate from 40% to 36% if 10% of chargeable estate left to charity – i.e. after NRB, BPR, labilities etc.) E.G: £1m estate with 5% legacy (after NRB) charity £33,750 IHT £256,500, pass on £709,750. Same estate with 10% legacy (after NRB) charity £67,500, IHT £218,700, pass on £713,800.
Typical Planning options
- Make sure will is in place first!
- Gifting of assets not standing at large gain and which income is not required from during lifetime (consider use of trust to protect assets)
- Utilising ordinary gifts out of income where capital is building up due to income exceeding expenditure
- Consider more bespoke planning options for larger estates with significant IHT otherwise payable
- Consider gifting assets on first death which will increase in value quicker than nil rate band
- Consider gifting exempt assets to non-exempt beneficiary (i.e. not UK domiciled spouse) or leave other assets to spouse in will then immediately gift on as PET to preserve deceased spouse’s nil rate band is remaining spouse is likely to survive the seven years
- Consider Deed of variation where planning not undertaken in lifetime (e.g. top up charitable donations from to 10% of net estate after NRB etc) – needs agreement of all beneficiaries so better to get it right in the will but this is a fall-back option. Can also use to pass on legacies from Grandparents direct to Grandchildren where the intervening generation does not need them.
- Consider leaving pension funds untouched – may be able to pass on free of tax if under 75 at death, or at recipient’s marginal tax rate if you are over 75 (only payable when income is drawn)
Planning your tax mitigation in advance
If you take action early enough, then it is often possible to significantly reduce your tax liabilities. This is especially the case in reference to taxes such as Capital Gains Tax or Inheritance Tax.
Too often, we are asked to advise once the inheritance is due to be awarded or when a gain is about to be, or has been, realised on the sale of land or property.
You can never start planning early enough.
The more time you have then the more opportunity you have to make any changes required to see the benefits. From HMRC’s perspective good planning in line with the tax legislation is prudent rather than last minute adjustments that can be viewed as avoidance rather than mitigation.
If you would like to discuss your personal circumstances and how you may mitigate your tax liability, then please call us on 01865 379272
© Chapman, Robinson & Moore Ltd (CRM) 2018. All rights reserved. This is an internal training document and should not be construed as advice. No responsibly may be taken by CRM for action taken, or not taken as a result of information in this factsheet.