Basics of mitigating Inheritance Tax Planning

simon

Simon Misiewicz

11th January 2017

What is Inheritance Tax (IHT)?

Inheritance Tax is a death tax, which is payable to HMRC at the rate of 40% above your IHT lifetime allowance, which we will come to a little later.

Lifetime IHT allowance

Each person is provided with a nil rate band for IHT purposes of £325,000. A husband/wife or civil partnership would benefit from an IHT lifetime allowance of £650,000 as they each get the £325,000 amount.

If this nil rate band has not been used upon death, it may be passed onto your spouse.

Any assets that are in your own name in excess of the above amounts will be subject to HMRC Inheritance Tax at the rate of 40%.

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Potentially exempt transfers (PET) - IHT planning

John has £500,000 worth of assets and he died. The estate would have to calculate John’s inheritance tax liability as follows:

– £500,000 gross asset value (please note that debts and any other liabilities reduce the gross asset value)

– £325,000 less the nil rate band

– £175,000 assets chargeable to IHT

– £70,000 IHT bill to be paid by the trustees

We have ignored the Residence Nil Rate Band (RNRB) as we pick this additional Inheritance Tax relief later.

If £200,000 value of assets were transferred (ignoring Capital Gains Tax for now) and they survived for more than seven years, then the IHT liability would be revised as follows:

– £500,000 original asset value

– £200,000 assets transferred

– £300,000 assets to be passed on

– £300,000 less nil rate band

– £0 subject to IHT

– £0 IHT liability

As you can see by some effective tax planning, the person would save £70,000 in IHT alone. At the end of the day, it’s your choice who gets the £70,000: your loved ones or HMRC.

A potentially exempt transfer (PET) is treated as exempt whilst the donor is alive. A PET will not give rise to a lifetime IHT charge. IHTA 1984, s.3A

A PET is fully exempt if the donor survives 7 years from the date of the gift. A PET will become a chargeable transfer if the donor dies within 7 years of making a gift. On the death of the donor within 7 years, an IHT charge will be levied and any tax will be payable by the recipient of the gift.

If there’s Inheritance Tax to pay, it’s charged at 40% on gifts given in the 3 years before you die.

Gifts made 3 to 7 years before your death are taxed on a sliding scale known as ‘taper relief’.

Years between gift and death  Tax paid

– less than 3  = 40%

– 3 to 4  = 32%

– 4 to 5  = 24%

– 5 to 6  = 16%

– 6 to 7  = 8%

– 7 or more =  0%

This means that any gift you make after 7 years will be free from HMRC’s Inheritance Tax

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Residence Nil Rate Band (RNRB) to reduce IHT on your private residence 

Inheritance tax is currently charged at the rate of 40% on estates in the UK worth more than £325,000. The government also introduced a Residence Nil Rate Band (RNRB) in April, helping to protect the main home asset by another £175,000.

This means that someone with a high valued home would benefit from the £325,000 Inheritance Life Time Allowance and the Residence Nil Rate Band of £175,000, giving rise to a tax-free amount of £500,000.

I’m also advising investors that couples can also pool their allowances, meaning they could leave a total of £1m before any inheritance tax is due.

Even though most Estates don’t pay inheritance tax – just seven per cent at the HMRC’s last count – a long-term freeze on the amount you can pass on before IHT is due (£325,000), means that this percentage is likely to rise considerably in the future. Effective tax mitigation planning can help to offset this.

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Capital Gains Tax (CGT) and transfer of assets

Making gifts during your lifetime is a good way to minimise IHT in the future. You do need to be aware that certain gifts of assets may give rise to a Capital Gains Tax liability if you transferred assets to other family members other than your spouse.

This is because HMRC deems the asset to have been sold at market value, and then compares the market value to the original cost of the asset.

Many people transfer assets to save on the 40% IHT tax but pay up to 28% CGT, which can be avoided. This all very much depends on the asset being sold and the income earned by the taxpayer.

Are you worried about Inheritance Tax (IHT)?

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Avoid IHT and CGT by passing assets to a terminal person.

Asset transfers between husband/wife and civil partners mitigate the Capital Gains Tax charge. For this reason it is sensible to gift assets from the heaty person to one that is terminal (12 months or less to live).

Why is this beneficial?

On death assets are passed from the deceased to loved ones at market value, not the original value according to IHT 1984 S.160

Option 1: Example of CGT if dispose of a property before death

For example, Sarah and John own a buy to let property. The market value is £200,000 with a purchase price of £100,000.

The gain would be £100,000 if sold. Capital Gains Tax would be chargeable on this amount at say 28% as high rate taxpayers being £28,000 ignoring CGT annual exemptions.

Option 2: Example of CGT if you dispose of a property before death without a gift.

John died during the year and Sarah decides to sell the property.

As the above example, the asset has a market value of £200,000. However, John’s 50% share was transferred to Sarah at market value on his death being £100,000.

This means that the deemed purchase value is £100,000 for John’s portion (market value) and £50,000 for Sarah.

This means that Sarah only has a gain upon selling the property of £50,000.

The tax charge at 28% will be less at £14,000.

Option 2: Example of CGT if you dispose of a property after death, with a gift before death to the terminal person.

Before John died Sarah made a gift to John of her share of the asset.

John now owned 100% of the property in the last 12 months of his life.

On death, the entire share of the property, owned by John, is passed onto Sarah in his will. The value of the property is passed to her based on the market value being £200,000.

On his death, Sarah sells the property at a market value of £200,000. There is no gain as the deemed cost is the market value at death being £200,000.

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A deed of variation

A deed of variation may be put in place two years after the deceased has passed. The assets may be gifted or put into a trust for another beneficiary other than the previous beneficiary (in this case dad).

If a beneficiary does not wish to accept a gift but instead wishes the property to pass to a nominated person, this can be achieved by using a Deed of Variation. The person making the variation will stipulate the new recipient within the Deed. Only persons relinquishing interest in an estate may make a variation.

The Recipients can be

– Members of the family or
– A trust

If an election is made under s.142 IHTA 1984, it is treated as creating a trust for his children on the death of the donor. This is important for the purposes of calculating exit and principal charges.

The Executors must consent to the variation if it results in more inheritance tax becoming payable. This would be the case, for example, if an exempt beneficiary such as a spouse or charity gave up their right to an asset, and that property thereafter passed to a chargeable beneficiary.

The Executors can refuse to give consent if there are insufficient assets left within the estate to cover the additional tax. IHTA 1984, s.142(2A)

If additional IHT is payable, the variation must be sent to HMRC within six months of it being made. IHTA 1984, s.218A

Disposal proceeds are equal to the market value of the asset at the date of the gift. The recipient’s base cost will be the probate value of the asset at the date of death. A gain will arise if the house has increased in value between the date of death and the date when the variation is made.

Where variations are made within a short period after the date of death, there is unlikely to be a substantial CGT liability.

Please note that the £ 325,000-lifetime allowance will be reduced by the assets transferred to a loved one by the deceased and not passed onto the surviving spouse.

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What are freezer shares and how can they minimise your IHT liability?

The creation of freezer shares is useful if you have a limited company that is not a trading activity based business. If you are a medic, consultant or have a service/product-based business then you can claim Business Asset Rollover if your children continue to run the business. However, if you have a limited company that holds investments such as buy to let properties then the asset value of the company will be subject to IHT on your death.

You can cap the value that you own in the business if you put in freezer shares. Let us look at an example. Sarah holds no other assets but her limited company. This company is used purely to buy and hold residential investments. If the value of the business is £500,000 on her death then the same £68,000 IHT liability applies. If she creates freezer shares to cap her ownership in the business to £325,000 then no IHT liability will arise. The rest of the business value of £175,000 will be based on to her loved ones or charity.

The practical steps of creating freezer-shares

OK, now we have identified the benefits of creating freezer-shares, how is it done on a practical level? If you follow the below steps, then you won’t go wrong:

– The articles of your Company are amended to create a new class of shares of 1p each with no rights. They will be able to benefit from the money obtained through the company disposal. These shares are pro-rata with ordinary shares, but only after ordinary shares have received a hurdle amount of say £5 per share, which is agreed up-front.

– There should be an option for the company to buy back the shares at 1p. If the family member leaves the company or if there is any falling out.

– The family member will need to pay up the 1p for each share that has been allocated.

– The family member needs to make an election in relation to section 431(1) ITEPA 2003, which requires them to pay income tax on the unrestricted market value of the growth shares within 14 days of acquisition. The family member may gain clearance from HMRC to say that the value of the growth shares does not carry an income tax liability as the market value had been paid.

How to create freezer shares -HMRC approval

You need to get valuation advice so as to set the hurdle applicable to the growth shares at such a level to avoid or minimise any income tax charges arising on an acquisition.

After 6th April 2016, HMRC requires companies and participants to retain a valuation agreement. This then protects the company and individuals from any unnecessary claims of income tax and national insurance.

As HMRC shows that the open market value of any of these assets is relevant to your tax affairs, your tax office may ask SAV to consider and, if necessary, negotiate the value with you.

You may have already passed an asset to another person. You will need to enter it on your tax return. Where it’s difficult to establish market value, SAV can help. This is called a Post Transaction Valuation Check. (PTVC).

Here you can find out:

– how share and assets valuations are to be valued

– how to submit or prepare a valuation of assets

– contact details for SAV

Property investors and developers please note SAV doesn’t value UK land or buildings for tax purposes. The Valuation Office Agency does this.

There is no requirement to offer participation in such schemes to all employees and the company has discretion as to who participates.

Finally, I strongly recommend working with experienced solicitors who will draft the share plan and associated documents including the necessary changes to the company’s Articles of association.

Are you worried about Inheritance Tax (IHT)?

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Three things you must get done regarding IHT

– Make a Will and ensure that it specifies people by their name(s) and the specific assets to be transferred to them

– Use your lifetime transfer allowance as stated above in ways to mitigate CGT & IHT

– Create an investment structure that pays any IHT liabilities without the need to dispose of any assets

Are you considering why you should make a Will?

One of the most popular topics of conversation with our property investor clients is always how to minimise inheritance tax or IHT, so that the financial assets gained from property investment are passed onto the next generation as tax-efficiently as possible.

Our team of property tax experts are on hand to best advise our clients on how to decrease inheritance tax on their property portfolios, as well as consider other elements of wealth planning for the future.

Intestate is a term used for people that have died and have not made a Will. This means that nobody really knows the person’s intention of how to divide up their assets.

People often leave this too late, because they think either that it is not necessary or that they are too young.

There may be other reasons such as the fear and unpleasantness of death itself.

As I say to all of my property investment clients, you can’t control death, but creating a Will to make it easier on those that are left behind is something that you can easily control.

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Who will manage your property/investment estate when you die?

As a property investor, you may be creating a lot of wealth. If there has been significant capital growth, it is likely that you have amassed a lot of net worth assets.

As such you may have caused a number of issues for the people that you leave behind when you die or if you become incapacitated. Our property tax experts assist with property asset management issues.

You would have built up a property portfolio, each asset with its own insurance, mortgages/loan accounts, and utility providers. You may also have Joint Ventures or loan agreements with other people with various legal contracts in place to consider. My team of tax accountants can discuss asset planning with you.

We suggest that you build a power team to support you in the event of incapacitation or death.

Powers of Attorney

Under the Powers of Attorney Act 1971, a person can empower another individual to act on their behalf. For example, with the operating and management of bank accounts, utilities and related matters.

For example, the operating and management of bank accounts, utilities and other related matters. You can work with your solicitor to draw up a document that specifies who the person is to become your Power of Attorney, the duration of their powers, and the specifics of their role.

The Enduring Powers of Attorney Act 1985 was introduced to enable a person to hold Power of Attorney which would continue to be in effect in the event of mental incapacity.

The Mental Capacity Act 2005 introduced Lasting Power of Attorney (LPA), which allows a person to make decisions whilst they are alive about their personal health and welfare (such as long-term care planning) and property/financial affairs.

If a person is to be given control over both matters then two separate documents are required, including Health & Welfare LPA and Property & Financial Affairs LPA. Don’t worry that the person in possession of the LPA can make significant gifts to erode your valuable assets – we can advise you further on this.

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Wills & executors /administration of your estate 

Typically the next of kin will act as the administrator of the Will, to ensure that your wishes are carried out correctly. They are known as the executors.

Collectively, executors and administrators of a Will are called personal representatives. They will be responsible to:

– Administer the estate

– Collect unpaid debts

– Pay any tax due

Before you jump to someone’s aid as a personal representative, you need to be aware that you would be liable for any unpaid debts and tax due. Personal representatives will need to ensure that these are paid before any distributions are made in accordance

Personal representatives will need to ensure that these are paid before any distributions are made in accordance with the Will.

Grant of representation

A grant of representation needs to be obtained by the executors of the Will, which will then allow them to administer the Will if the assets left are worth more than £5,000.

This will be done after they have completed an HMRC form to show the assets and liabilities of the deceased.

Are you worried about Inheritance Tax (IHT)?

Tell us about you Inheritance Tax issues to see if we can help you.

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Grant of letters of administration

A form needs to be obtained called ‘Grant of letters of administration if the deceased did not leave a Will (known as intestate). They will still need to ensure that tax and debts are paid but the remaining assets will need to be distributed.

They will still need to ensure that tax and debts are paid but the remaining assets will need to be distributed as per the laws of intestate.

Trustees

You may have had tax planning support and decided to transfer assets into a Trust. We have written about Trusts in a previous article so I shall not go into detail here. A trustee also manages the Trust in regards to its financial affairs, debts and tax liabilities.

As a rule of thumb, in order for a Trust to be in place, three components must be in existence:

– The words: to show how the Trust is intended

– The subject matter: The property/asset that is being discussed in the Trust

– The objects: the beneficiaries of the Trust and how the trust will transfer both income and capital to them in a specific time period

The trustees will become legal owners of the property and will, therefore, need to take possession of the legal artefacts such as a Deed of Trust, conveyance documentation, and share certificates.

They will also need to ensure that their names appear as the legal ownership at Companies House and Land Registry.

The trustee will become legally responsible for the assets in possession and may make financial decisions to buy/sell shares, properties for the benefit of the Trust.

Interestingly, Section 31 of the Trustee Act 1925 provides the trustee with powers to apply trust income to any infant beneficiary in order to provide for their maintenance/education. More on this in a later article.

The trustees will also be responsible for ensuring that the Trust submits its tax return each year.

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What other areas of risk around IHT400 can impact you?

The third area of risk for property investors when completing an IHT400 form is that of observing the correct legislation around tax liabilities. Every year, HMRC reviews IHT400 forms where the submissions do not meet current legislative requirements.

Keeping up-­to­-date with legislative changes is not easy, and searching through guidance is time-consuming, as I advised my buy-to-let landlord client during our wealth planning review meeting.

The fourth risk area when it comes to assessing inheritance tax liabilities that many property investors can fall foul of is around record keeping. Good record-keeping is essential.

An absence of clear and concise records can mean that information provided is not accurate, and these mistakes are in turn passed on to HMRC. This will also mean an inaccurate IHT liability is in place.

I advised my client that when completing form IHT400 it is the deceased’s records which they are required to obtain and rely on. This can cause difficulties if those records are incomplete.

The type of records which I advised my buy-to-let landlord client to retain include:

– Gifts. Although it is Gifts made within seven years of the date of death that are important, it’s advisable to keep records at all times.

– Lifetime Transfers: Keeping careful and detailed notes and valuations of lifetime transfers, and having access to detailed inventories of assets makes it easier to gather the relevant information to complete form IHT400 correctly.

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Payment of IHT

IHT is payable by the estate within 6 months of the person passing. As an example, for someone that died in January, you must pay Inheritance Tax by 31 July. You will need to get a payment reference number before you can pay your Inheritance Tax bill. This is a 15 digit code and may be requested from HMRC using the form

You can pay your Inheritance Tax on things that may take time to sell in equal annual instalments over 10 years.

You must say on Inheritance Tax Account form IHT400 if you want to pay in instalments.

You’ll usually have to pay interest on your instalments. Use the calculator to work out the interest you’ll need to pay.

What you can pay in instalments

Houses – You can pay 10% and the interest each year if you decide to keep the house to live in.

Shares and securities – You can pay in instalments if the shares or securities allowed the deceased to control more than 50% of a company.

Business run for profit – You can pay in instalments on the net value of a business, but not its assets. Albeit you can claim Business Asset Rollover if the business was a trade activity (professional services, selling products etc)

Agricultural land and property – This is rare because most agricultural land and property is exempt from Inheritance Tax.

Unlisted shares and securities – You can pay in instalments for ‘unlisted’ shares or securities (ones not traded on a recognised stock exchange) if they’re worth more than £20,000 and either of these apply:

– they represent 10% of the total value of the shares in the company, at the price they were first sold at (known as the ‘nominal’ value or ‘face value’)

– they represent 10% of the total value of ordinary shares held in the company, at the price they were first sold at

– You can find the face value of a share and whether it’s an ordinary share on the share certificate.

Are you worried about Inheritance Tax (IHT)?

Tell us about you Inheritance Tax issues to see if we can help you.

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Ways to minimise IHT - Lifetime allowances

Utilise your lifetime transfer of any amount and provided they live for seven years there would be no IHT. There could also be a Capital Gains Tax (CGT) liability if assets that have increased in value since purchase have been made (other than their main home because of Private Residency Relief).

£325,000 one person
£325,000
£650,000 gift allowances and avoid IHT on this amount if die within 7 years into a trust

You can gift assets of more than £325,000 in any year, just not to trust without paying a 20% IHT entry charge.

As such you can gift assets of say £1m and not have any tax issues unless you pass away within 7 years.

Ways to minimise IHT - Increase debt

Increase the level of debt to reduce the amount of assets, which in turn reduces the amount of IHT. An example of this is lifetime mortgages on your own home (if unencumbered)

£425,000 net asset value
£325,000 IHT lifetime allowance
£100,000 Excess over IHT lifetime allowance
£40,000 IHT at 40% charged on the excess

Raise debt

£425,000 gross asset value from the above
£100,000 mortgage/loans – spend this money
£325,000 net asset value revised

£325,000 IHT lifetime allowance
£0 IHT

Care must be taken with mortgages. These will need to be paid off within 12 months upon the death of the mortgage holder, compared to IHT that may be paid over a 10 year period.

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Ways to minimise IHT - Pension contributions

Pension contributions. If you invest money into a pension it will decrease your bank account(s) and move the funds into a UHT shelter. It is also possible to sell IHT chargeable assets and reinvest the proceeds into a pension fund.

This is particularly useful if you have not made pension contributions for the last few years. You can go back 3 tax years in addition to the current year. Each person is entitled to contribute themselves (if they have enough taxable income) or via their limited company.

£40,000 current year
£40,000 prior year 1
£40,000 prior year 2
£40,000 prior year 3
£160,000 total allowed pension contributions

£64,000 Potential IHT saving (£160,00 X 40% IHT charge)

Not only will you save on IHT but you will also save

– Income Tax if you have personally made pension contributions

– Corporation tax if the limited company has made the pension contributions.

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