Wednesday, October 21, 2015

Five tips to mitigate Inheritance Tax in the UK

Inheritance Tax (IHT) in the UK can be extremely punitive. For spouses or civil partners there is no tax to pay but for anyone else, the IHT rate is 40% for sums above the nil rate band (NRB) of £325,000 per individual.

It does not have to be. There are a number of ways one can significantly reduce this tax with a little bit of estate planning. Here are 5 tips you need to keep in mind when it comes to IHT:

1. Gifts from disposable income

This is actually an HMRC concession that most people are unaware of. It relates to the ability to give away an unlimited amount provided it qualifies as "normal expenditure out of income" and it is arguably one of the most useful IHT exemptions. It is also very flexible, because you don't have to gift the same amount every year or make the gifts to the same person. Many people use the exemption to pass on money on a regular basis to children or grandchildren. It is important to remember however that the exemption is not given automatically and has to be claimed retrospectively by the executors of your estate. For the gifts to qualify, you must be able to show that the payments are made out of surplus income - either earned income or investment income - and that they do not reduce your standard of living and in particular you cannot pass on income and then use your capital to supplement living costs.

2. Gifts of capital survived 7 years

There is a way to give your whole estate away and pay no tax at all. As long as you survive the gift by 7 years or more. This type of transfer is known as a "Potentially Exempt Transfer" or a PET. It is important to bear in mind that when making a large gift it has to be in excess of the nil band rate (NBR) to benefit from any potential reduction in the potential tax due as a result of the taper relief. In addition it is also important to be aware that any gift made essentially uses up the nil rate band and could push the remaining estate into a full rate of tax with no relief at all for the subsequent 7 years.

Keep in mind that if you give your estate away, you don't control it anymore. Something that many people are reluctant to do. But there is another option. Please read on....

3. IHT free investments such as Enterprise Investment Scheme (EIS)

If you are not risk averse, EIS and EIS schemes allow you to invest IHT free in private companies. The popularity of the EIS and more recently SEIS schemes has increased over the years because of their amazing tax benefits. On top of being 100% inheritance tax exempt after they have held for two years, investors can claim income tax relief on up to 30% of the value of their EIS investment (50% for SEIS) up to a maximum of £1 million in each tax year ($100K for SEIS). Moreover, investors facing capital gains tax liabilities on other investments can use their EIS or SEIS investment to defer the capital gains. Lastly investors don't have to pay any tax on gains made from the sale of their EIS or SEIS shares.

4. Business Property Relief (BPR)

This one is not widely known and yet it's probably the most important relief. It allows to give your money away tax free while keeping control, something that PETs won't do. BPR enables you to claim relief on any business assets that you own but also shares in qualifying businesses. Companies that qualify for BPR are unquoted businesses (although this definition includes AIM and Plus markets) that actively trade. That is, they cannot be an investment company (although property developers would be ok). As long as you have held such a business (or shares of such a business) for 2 years or more, there will be no IHT due on death.

Some creative investments firms such as Ingenious have stepped in to offer low risk income generating funds that qualify for BPR allowing tax free transmission. Moreover if you use that scheme in conjunction with Business Asset Rollover Relief (which allows you to defer capital gains when business assets are sold and when other business assets of the same value are purchased) and Replacement Relief (which allows a business owner to not have to wait for 2 years for the BPR relief to come into effect if he has sold a business equivalent in value in the last three years), a business owner could sell his business, invest into a BPR fund and never have to pay IHT.

5. CGT and IHT

Last point to remember, death is not an occasion of charge for Capital Gain Tax purposes. Tax people love to say that dying is the best way to mitigate CGT and it's true! So it does make sense to defer capital gains as far as possible (as per the previous point) as those will just disappear upon death.

P.S. You will have noted that I have not mentioned trusts that you always hear about in relation with inheritance tax mitigation. The reason is that their benefits have been curtailed a lot recently and that consequently it is very often more cost effective to just put in place a life insurance to cover the tax in the event of death.