Keeping the taxman out of your home

Transcription

1 Keeping the taxman out of your home A guide to inheritance tax planning 2013/14 edition

2 Written by John Kelly BA FCA Published by Knill James Wealth Management Limited, One Bell Lane, Lewes, East Sussex BN7 1JU Telephone: Fax: Website: ISBN Contents Page About the author 2 How Inheritance Tax works Chapter 1 How much of a problem is this for you? 4 Chapter 2 The charge to tax 7 Chapter 3 Basic allowances 10 Chapter 4 More complex allowances 13 Chapter 5 Interaction with Capital Gains Tax 17 Chapter 6 Some tax traps 19 How to avoid Inheritance Tax Chapter 7 Gifts 23 Chapter 8 Wills 24 Chapter 9 Insurances 26 Chapter 10 Annuities 28 Chapter 11 Trusts 30 Chapter 12 Planning using Investments 33 Chapter 13 Business Property Relief 41 Chapter 14 Equity release 43 Chapter 15 Pensions 44 This book is for general guidance only and represents our understanding of law and Inland Revenue practice. We cannot assume legal liability for any errors or omissions it might contain. No comments constitute advice or a recommendation. When considering investment, independent advice should be sought which will take into account individual circumstances. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise, without prior permission in writing from the publishers. Chapter 16 Conclusion 49 Appendix 50 1

3 About the author How Inheritance Tax works John Kelly is a chartered accountant and director of Knill James Wealth Management Limited. John obtained his degree in economics at Manchester University in 1981 and then qualified as a chartered accountant with one of the UK s leading accountancy firms, Stoy Hayward, in In 1988 he started his own accountancy practice, which provided tax-saving strategies to owner-managed businesses. The firm put financial planning at the core of its business. In 2003 he merged his practice with one of London s leading accountancy firms and in the same year acquired a share in a long established firm of independent financial advisers. John s speciality is in providing clear explanations of complex tax issues to non-professionals. When not working and lecturing, John enjoys sailing, astronomy and the outdoor life. He lives in Sussex. Page Chapter 1 How much of a problem is this for you? 4 Chapter 2 The charge to tax 7 Chapter 3 Basic allowances 10 Chapter 4 More complex allowances 13 Chapter 5 Interaction with Capital Gains Tax 17 Chapter 6 Some tax traps

4 Chapter 1 How much of a problem is this for you? Chapter 1 How much of a problem is this for you? 1 How much of a problem is this for you? Before reading this book let s assess whether you have a problem at all. If you don t want to write in the book this form is available at: By entering the approximate values in the boxes below, you can calculate how much inheritance Tax (IHT) could be charged on your estate. If you are married or in a registered civil partnership, enter the total value of all joint assets. Do not include any assets under trust, unless your spouse or civil partner is the beneficiary of that trust (except discretionary trusts). Your assets Property Main residence Other residential property in UK or abroad Buildings occupied by a business you control (50% of value) Investments Bank and building society accounts National Savings and Investments ISAs Quoted equities & gilts Venture capital trusts Investment trusts & unit trusts Investment bonds & guaranteed income bonds Life assurance policies (sum assured not in trust) Other investments Death in service benefit (including return of pension funds see note 2) Total B Personal assets House contents and other valuables Cars, personalised number plates, caravans, boats, aircraft etc Gifts made within the last seven years (see note 1) Total a Your liabilities and proposed charitable gifts Mortgages Loans and financing Credit cards Other liabilities Charitable gifts on death Total C Note 1: You only need enter the total gifts made in excess of 3,000 p.a. (If married, 3,000 p.a. each.) Gifts made directly from income on a regular basis (e.g. 100pm) do not need to be included in this calculation. Note 2: If you have a pension fund, this would not normally form part of your estate unless your spouse is the nominated beneficiary. If so, include the value of the fund under the Investments section. 4 5

5 Chapter 1 How much of a problem is this for you? Chapter 2 The charge to tax Calculating your taxable estate Add the total A to total B and deduct from it total C Identify the nil-rate band (see note 3) Take the figure in D and deduct from it the figure in E Your potential tax liability Take the figure in F and multiply it by 40% D E F This is your potential Inheritance Tax liability, unless you take action to reduce it 2 The charge to tax On death IHT is levied at 40% on the value of your worldwide taxable estate on death (assuming you are domiciled in the UK see later notes about domicile). Your taxable estate, at its simplest, is made up of your: Assets (such as your home, property and investments) + any Life Insurance and Personal Pension Policies not in trust + your Interest in the Capital of Some Types of Trust + any Gifts Made in the Last Seven Years (less the 3,000 annual or other exemptions) - Funeral expenses - Debts = ESTATE ASSETS DEBTS Your assets include everything of value you own. This includes investments, such as ISAs, which you took out thinking they were tax-free. Now all the gains you made tax-free will suffer higher rate tax! Your debts include all that you owe, including your mortgage, loans, hire purchase and credit cards. Note that many finance agreements are sold with in-built life cover so you need to add the life insurance element to your assets. Note 3: Nil-rate band: If you are single the appropriate figure is 325,000 for 2011/12 to 2014/15. If you are married or a civil partner, you may be entitled to transfer any unused nil-rate band from your spouse, in which case enter 650,000 for 2011/12, otherwise enter 325,

6 Chapter 2 The charge to tax Chapter 2 The charge to tax The liability for the tax on death is generally met by the executor or personal representative (the person nominated to handle the affairs of the deceased person) and it is settled out of the assets of the estate. The Probate Registry will not grant probate until the tax is paid. There can be some exceptions to this rule, and it is possible for the beneficiaries themselves to have to pay the tax. For example the recipient of a particular bequest may be liable for the tax, although you can set up your will so that the bequest is paid net of tax. Any gifts in excess of the nil-rate band made within seven years before death will result in a tax charge on the recipient, unless the gift was specifically made net of tax. It is important to realise that IHT is charged in the UK on all your assets wherever they are. For example, it is not relevant that there is no IHT in the country where you have your holiday home. It is possible that overseas assets may be subject to the equivalent of IHT in the local jurisdiction. IHT works differently if you are not domiciled in the UK. Domicile is a complicated topic which is really outside the scope of this book, but its broad meaning is your country of permanent residence. Domicile is acquired at birth and is difficult to change. If you are not domiciled in the UK, only your UK assets are liable for Inheritance Tax. Even if you are not domiciled in the UK you are treated ( deemed ) as if you were so domiciled for IHT purposes, if you were either: l Domiciled here in the three years prior to making a transfer, l Have been resident here for 17 out of the last 20 income tax years. The charge to tax - during lifetime If you make payments into a trust you may have to pay a lifetime tax charge of 20%. These issues are covered more fully in chapter 11 Trusts. Prior to 22 March 2006 this affected only discretionary trusts but since 2006, nearly all trusts are affected. In addition, nearly all trusts set up after 22 March 2006 are now liable for a periodic tax charge. This is levied every ten years at the rate of 30% of the lifetime rate on the value of the trust which exceeds the then nil-rate band. In 2013/14 that rate is 20% so the periodic charge is 6%. This calculation is complicated and you will need to take advice in every case. Example Ethel put 200,000 into a trust in 2003/2004. In 2013/14 it had grown to 400,000. The IHT threshold in 2013/14 is 325,000 Periodic charge is Value 400,000 less: Threshold (325,000 ) 75,000 Tax at 30% of 20% i.e. 6% 4,500 Payment of tax on death In most cases IHT has to be paid within six months of the end of the month of death. Interest is charged after this period. The tax on land and building can be deferred and paid by half-yearly instalments over ten years, with interest. 8 9

7 Chapter 3 Basic allowances Chapter 3 Basic allowances 3 Basic allowances There are various basic allowances which everyone should use: The nil-rate band There is an exempt amount which is announced in each budget. For the tax year 2013/14, when this book was last updated, the allowance is 325,000. It has been frozen at this level until 2017/18. This is the amount above which tax is paid, and it is paid at 40% on death (or in some situations during lifetime at 20%). Every person has this allowance. Before October 2007, the allowance was not transferable between spouses. Until then, it was necessary to engage in some rather complicated planning using wills to use both nil-rate bands for a married couple. Now, on the second death, the unused portion of the first deceased s nil-rate band is available. This only applies to married couples or to those in registered civil partnerships. Note that wills written before 2007 should be reviewed to remove clauses that were put in solely to assist IHT. The transferable allowances are now retrospective where the second death took place after October 2007 and so widows and widowers may re-acquire their deceased spouse s allowance. As this transferable allowance is retrospective without limit, all widows and widowers should find out what happened on the death of their spouse and keep a good record. The longer this task is left the harder it will be to find the detail. The limits for Capital Transfer Tax from 1975 to 1985, and the earlier allowances of Death Duty, are available on the HMRC website Example: Fred died in December 2002 when the nil-rate band was 250,000. Under his will, he gave 50,000 to his son and the balance to his wife Ethel. This bequest to his son represented 20% of his nil-rate band. Ethel died in December 2012 when IHT nil-rate band was 325,000. Ethel s executors can claim 80% of the nil-rate band, which is 260,000. This is, actually more than the total nil-rate band that was available to Fred. The claim for Fred s allowances must be made within 24 months of the end of the month of Ethel s death, so by 31 December The claim is made using form IHT 402 available from the HMRC website: The annual gift allowance The tax-free annual gift allowance is 3,000 per person per tax year. If the allowance is not used in one year it can be carried forward and used in the next but only once. If you do not use this allowance in one year the maximum you can give away the next year is 6,000 and 3,000 a year thereafter. Your spouse can do the same so you could make a gift to him or her first, using the inter-spouse exemption (see below) and effectively double your allowance. The small gift exemption Everyone can give away any number of small 250 gifts. These are limited to one gift per recipient and they cannot be combined with any other exemption. You cannot give a larger sum and claim that the first 250 is exempt. The gift in consideration of marriage exemption Gifts can be made to the bride and groom on the occasion of marriage up to the following values: Parent 5,000 Grandparent 2,500 Between bride and groom 2,500 Any other person 1,000 The inter-spouse exemption All gifts between married couples or registered civil partners are exempt from IHT provided that the person receiving the gift is domiciled in the UK. If the recipient is not domiciled in the UK the amount is limited (in 2013/14) to 55,000. There is no limit on transfers from a non-domiciled spouse to a UK domiciled spouse

8 Chapter 3 Basic allowances Chapter 4 More complex allowances Note that spouse includes a registered civil partner. A spouse from whom you are legally (or habitually) separated may no longer qualify for the exemption. There is no exemption for gifts between cohabiting couples beyond the annual and small gift exemptions or gifts out of income. Charitable gifts Gifts to UK charities, some political parties (subject to restrictions) and gifts for heritage/national purposes are also exempt from IHT. Gifts for national purposes include the National Trust, the British Museum, the National Gallery, any local authority, or university, and a number of other public institutions. Land given to a housing association is also an exempt transfer. The list of possibilities is extensive and you can ask HMRC for help. For those with no beneficiaries these are ideal ways to ensure that you choose where 100% of your wealth goes. 4 More complex allowances Potentially exempt transfers In addition to the allowances in chapter 3 anyone can give away ANY amount to another person and provided they survive by seven years (and one day) no IHT is due. Such a gift is known as a potentially exempt transfer or PET because it is potentially exempt from IHT. Similarly, gifts to certain trusts were potentially exempt until 22 March 2006 but NOT gifts to discretionary trusts, which were chargeable lifetime transfers. From 22 March 2006 most gifts into trusts are chargeable lifetime transfers. Lifetime IHT charged at 20% will be due only if the transfer (taken together with any other transfers into trust in the past seven years) exceeds the nil-rate band. Note that complications can arise here and you always need to seek professional help when thinking about making gifts into trust. Please refer to chapter 11 for a brief introduction to trusts and IHT planning. Gifts out of income One of the least understood allowances is the relief for regular gifts out of (after-tax) income. Note the words regular and income. Without delving too deeply into the rules, this allowance works if you can make regular gifts without running down your capital. The gifts need not be of the same amount each year, but need to be part of a regular pattern. For example, replacing your son s car every two years would be regular. There is no limit to the amount of the gifts provided the person making the gift is left with enough to maintain their normal standard of living without depleting capital. Normality will vary greatly from person to person. There have been cases where a single payment has been held to be regular but this was exceptional. It is best to set up payments early and be sure to document your intentions at the outset just in case you die before you expect

9 Chapter 4 More complex allowances Chapter 4 More complex allowances Some readers may have investment bonds from which they enjoy a 5% a year tax-free income. Unfortunately, this is not technically income but a return of capital and so exempt gifts cannot be made from this income stream. With all gifts, you should write a covering letter to the recipient explaining your intentions, and keep copies of these letters with your will. You should also keep very detailed records of your income and outgoings for every year in which you intend to rely on this gift. HMRC have changed their practice in this area and there is now a detailed page IHT 403 (P6) on the Inheritance Tax Return form (see Maintenance of family Any expenditure for your spouse, and any expenditure for the maintenance, training or education of a child under the age of 18 (or in full time education on 5 April before the expenditure was incurred) is exempt. Child here includes any adopted child, step child and child born outside of marriage. Maintenance of dependant relative There is an exemption for the reasonable provision to maintain a dependant relative, the relatives being restricted to: l A widowed, divorced or separated mother; or l Any other old or infirm relative who cannot maintain themselves. Business Property Relief/Agricultural Property Relief Anyone with a business or farm should talk to their accountant or solicitor about Inheritance Tax Planning. Some business assets are completely exempt from IHT. It would be impossible to list everything but here are some examples: l Shares in your own business, provided the business qualifies for the relief ask your accountant. l Qualifying shares in some AIM companies ( Alternative Investment Market the junior stock exchange), provided the company s business qualifies for the relief. l Enterprise investment schemes ( EIS ), provided the business qualifies. l 50% of controlling interests in quoted companies. l Many assets used in your own trade. l 50% of land and buildings used in a business controlled by you. l 100% of agricultural land (including some tenancies from August 1995). l 50% of other tenanted agricultural land. Note that furnished holiday lets no longer qualify. Note that for agricultural property relief to be claimed, the land must be in use for genuine agricultural purposes, and so hobby farming may not qualify. There are minimum holding periods before these assets become exempt from IHT, usually two years

10 Chapter 4 More complex allowances Chapter 5 Interaction with Capital Gains Tax Qualifying trades Only those businesses which engage in a qualifying trade are eligible for Business Property Relief. This is a complex area and you need to ask your accountant for guidance. It is unlikely that any business that is not carried on for gain will qualify; this could include some stud farms and hobby businesses. The relief can easily be compromised or lost if your company owns significant non-trading assets. Such assets include investments in equities, investment property and even too much cash. If you run a business, talk to your accountant early and, if appropriate, clean up your balance sheet. 5 Interaction with Capital Gains Tax Capital Gains Tax ( CGT ) is a tax charged on the disposal of certain assets. Disposal can include a gift between connected parties and in that case full market value is used as the deemed sales value. It is possible to create a nasty CGT shock while planning to avoid IHT. CGT deserves a book to itself so the following notes are greatly simplified. One problem is that the tax has changed quite significantly over the course of the last 25 years. Generally, when tax is due it is worked out as follows: Sales proceeds X Cost of selling ( X ) Net sales proceed X Purchase price (or 1982 value) ( X ) Acquisition costs ( X ) Total purchase costs ( X ) Gain X However, any asset bought before 1982 is automatically revalued to its value on Budget Day (March) 1982 so any gains arising before that date are extinguished. Ascertaining the value on Budget Day 1982 can be a problem if it was not recorded at the time. Although a variety of regimes operated from 1982 to 2008, from 23 June 2010 the Chancellor changed rates to 18% or 28% of the gain as calculated above. For a business a 10% tax rate Entrepreneurs Relief operates on gains up to 10 million

11 Chapter 5 Interaction with Capital Gains Tax Chapter 6 Some tax traps On death UK CGT is extinguished. The assets are revalued at the date of death and are assessed to IHT instead. The reason for going into all this is the interaction between CGT and IHT. You may decide to give something away which contains a large CGT liability and in doing so cause two problems. This is explained below. Suppose you are single and have an estate for IHT purposes of 500,000. You had bought an asset two years ago for 60,000 which has grown in value to 100,000. You decide to cash in your gain, but then die soon afterwards. Capital Gain Proceeds 100,000 Cost (60,000 ) Gain 40,000 Annual exemption (10,600 ) 29,400 CGT at 28% 8,232 Proceeds 100,000 Less tax (8,232 ) Banked 91,768 On death, IHT of 40% of 91,768 falls due which is 36,707. Your estate pays over 36,707 and your children get the remaining 55,061 (i.e. 91,768-36,707). HMRC has collected 8, ,707, which is 44,939 instead of 40,000. If you had left the asset in your will instead the CGT would have been nil, and the IHT 40,000. So just by selling the asset you increase the tax by at least 12%. If you had given the asset away, you would still have had to pay the CGT, as you cannot avoid CGT by making a gift. However, if you did give it away you would have to find the CGT out of your own pocket leaving you 8,232 out of pocket in your own lifetime! Note that this all relates to UK Capital Gains Tax and that you must take local advice about assets in other jurisdictions. 6 Some tax traps Gifts with reservation of benefits ( GROB ) In simple terms, if you give something away but retain an interest in it, you haven t really given it away. If you try this as an IHT planning tool it will almost certainly fail. Examples include: l Giving away all or part of your home to your children, but continuing to live in it without paying a full market rent. l Giving away a painting, but leaving it hanging on your wall. These gifts fail because you keep an interest in ALL of the asset i.e. you lived in all of the house and you had the exclusive enjoyment of the painting. You can contrast these with some methods which should work: l Giving away part of your home when the recipient moves in with you and shares costs proportionately. l Giving away a part share of a holiday home to your children, provided the children use it and you all contribute proportionately to the running costs. This is an area which is fraught with difficulty and there have been several adverse high profile cases. You will need to take professional advice over any gift where you intend to continue to enjoy some benefit. Pre-Owned assets Tax or POAT POAT is an anti-avoidance tax aimed at the more abusive IHT schemes, although it can catch perfectly innocent tax-planning arrangements. It is regarded as a dreadful development in UK tax as it was the first piece of retrospective tax legislation. Even though it was introduced in 2004, and applied from 6 April 2005, it can apply to any gift made after 17 March

12 Chapter 6 Some tax traps Chapter 6 Some tax traps Pre-owned assets tax applies where someone gives an asset away but still enjoys its use. This includes gifting the funds to enable someone else to acquire the asset. The donor will be liable to POAT as an annual Income Tax charge. In the case of land, the tax will be payable on the open market rental value. In the case of chattels, the tax will be payable on the notional interest on the value of the asset. The official rate of notional interest is 4% for 2010/11 onwards. An example of a transaction which could be caught by POAT is a gift of capital to your child who uses it to buy a holiday home which you then use without payment of a commercial rent or full proportionate contribution. Similarly, it could apply if you give the holiday home to your children but continue to use it without paying a full commercial rental. In cases where POAT applies it is taxed at taxpayer s marginal rate:- Taper relief There is a time related relief for gifts so that the amount of tax charged on the gift reduces after 3 full years by 20% a year from years 3 to 7. For this relief to be claimed there must be tax charged on the gift. The relief cannot therefore affect the first 325,000 of gifts, since these are covered by the nil-rate band (and therefore no tax is due). If no tax is due it cannot be tapered. Years after death Taper relief % % % % Example Example If the annual rental value of a house subject to POAT is 12,000, a higher rate taxpayer would have an additional Income Tax charge of 4,800 per annum (i.e. 40% x 12,000). If a painting worth 150,000 is subject to POAT, the notional interest at 4% is 6,000 on which a higher rate taxpayer would pay Income Tax of 2,400 per annum (i.e. 40% x 6,000). In the case of assets such as stocks and securities, insurance policies and bank accounts POAT is payable on the annual value. Again this is based on a notional rate of interest, as in the case of chattels, currently 4%. Where the notional interest is below 5,000 per annum no charge applies. Ted made a gift of 350,000 in 2002/3 and died in 2006/7. The amount of taper relief relating to the gift was Gift 350,000 Less: nil-rate band in 2006/7 ( 300,000 ) Gift subject to taper relief 50,000 IHT due on 40% = 20,000 Taper relief (3-4 years) 20% ( 4,000 ) Where a taxpayer is liable to POAT, it can be avoided if the taxpayer elects instead that the gift is a gift with reservation of benefit i.e. that it is ineffective for IHT. Tapered tax 16,

13 Chapter 7 Gifts How to avoid Inheritance Tax 7 Gifts Page Chapter 7 Gifts 23 Chapter 8 Wills 24 Chapter 9 Insurances 26 Chapter 10 Annuities 28 Chapter 11 Trusts 30 Chapter 12 Planning using Investments 33 Chapter 13 Business Property Relief 41 Chapter 14 Equity release 43 Chapter 15 Pensions 44 Chapter 16 Conclusion 49 Appendix 50 To be effective for IHT a gift must be outright, which means that you must be able to afford to make it. Provided you can afford it: l Give away 3,000; and if you didn t make a gift last year, give away 6,000 this year and 3,000 a year thereafter. If married or in a registered civil partnership you can double these figures. l Give away any number of smaller gifts of 250 per recipient (you can t give 250 to someone who has already had all or part of your 3,000 annual exemption or give more than 250 to anyone). l Make a gift on marriage up to the limits mentioned in chapter 3. Even a dying person can engage in this simple planning by making deathbed gifts, and save at least 1,200 or ( 2,400 if no gifts were made last year). If you have an income which exceeds your outgoings, you can give away the surplus as well as the 3,000 annual limit. This relief is very valuable and is available provided the gift is regular and does not deplete capital. Example: Fred has an income, after tax, of 38,000. His outgoings are 27,000 a year. The surplus, 11,000 may be given away. If you want to use this exemption, make sure you record the gift and make sure you have some evidence of your intention to make it regular. For example write to the recipient to express your intention. Also, record your income and outgoings in the format set out on HMRC form IHT 403 (P6), available on the HMRC website: Other ideas include paying into pension plans for children or grandchildren (see chapter 14 for more information). Remember that if you set up a whole of life or gift inter-vivos insurance and put it in trust, the premiums you pay are gifts and they reduce the available annual exemptions

14 Chapter 8 Wills Chapter 8 Wills 8 Wills Everyone should have a will. A will is vital to make sure the right people inherit your estate after your death. It is also useful in showing your intentions over the guardianship of any minor children. If you do not leave a will you are said to die intestate. Please see Appendix 1 to find out the details. The basic consequence is that everyone you leave behind suffers and a spouse is likely to be left in a financial mess. So make a will! For some reason lawyers have tended to use wills as a loss leader and many charge very little for writing wills and worse, there are lots of unqualified will writers and DIY will-writing kits around. Do yourself a big favour and spend a sensible amount of money with a properly qualified and insured professional. From 10 October 2007 a welcome development occurred when IHT allowances became transferable. Now, no planning is needed for the nil-rate band of the first of a married couple to die to be available on the second death. Until October 2007, it had been widespread practice to set up a discretionary trust on the first death and for the nil-rate band to be put into the trust. Several problems arose. For many, there was insufficient spare money to set up the trust. In these cases some of the matrimonial home was put into trust. This in turn led to problems over stamp duty, legal fees, trust fees and Capital Gains Tax. In addition, worries were expressed that HMRC might attack such arrangements as a sham was it really a matter of discretion if the surviving spouse was the only occupant of the property? Other arrangements emerged where instead of the house going into trust a debt was created (the survivor owed the trust an i.o.u ). All of this was complicated and expensive and generally its sole purpose was to transfer IHT allowance between spouses. Any wills from before 2007 need a review. The new rules make the transfer automatic, subject to a claim being made within 24 months of death. Note that it is the unused proportion of the nil-rate band that is transferable, not the unused amount. Example Bill died on 31 March 2003, when the nil-rate band was 250,000. In his will he left 100,000 (i.e. 40% of his nil-rate band) between his children and gave everything else to his wife Elsie. Therefore 60% of his allowance amounting to 150,000 was unused. Elsie dies on 31 March 2011 when the nil-rate band was 325,000. Elsie s personal representative claimed 60% of the 2011/12 allowance for Bill i.e. 195,000, rather than the 150,000 of the allowance unused on his death, with the claim being made by 31 March In some situations settling assets into a trust on the first death is still very wise for example to be sure that your children inherit your estate after your spouse dies. If your spouse should remarry and either fail to make a new will or leave all his or her estate to the new spouse, your wealth could pass to complete strangers. You may also have concerns about the ability of your children to handle money, or you may not like their spouses. There is a debate about whether those who have enough investment assets should consider a will trust, in preference to using the first spouse s nil-rate band on the second death. On the one hand the latter ensures an increasing tax-free allowance as the nil-rate band increases each year (note that the allowance has been frozen until 2017/18). Against that, any growth in the trust is outside the estate of the second spouse for IHT. If the trust grows by more than the nil-rate band, the will trust would be preferable. In concluding this chapter I would advise you to review any existing will, particularly if it contains a nil-rate band discretionary trust

15 Chapter 9 Insurances Chapter 9 Insurances 9 Insurances In this chapter we look at how you can use insurances to pay for the IHT. Don t be fooled here. Insurance is NOT avoiding the tax any more than car insurance avoids accidents it is providing the means for your loved ones to pay it. Since insurers provide insurance to make a profit it must follow that in the economy as a whole it would be cheaper not to insure and for everyone to pay the tax due. However, that is not the point of insurance, which is to spread risk, albeit at a cost. Insurance can pay high commissions, so beware of advisers trying to make a quick buck. Be very careful to calculate both the value of your estate and how much you can afford to pay. A large proportion of plans are cancelled, which suggests that they are not well understood either by consumers or advisers. If you run a business, make sure that your adviser understands Business Property Relief. There have been cases where insurance has been taken out when there was no Inheritance Tax liability! There are two main types of insurance that are used for IHT planning: Gift inter-vivos insurance This is an insurance plan that is used to cover the Inheritance Tax liability on a gift. It lasts for seven years and the cover reduces to reflect taper relief. The policy is placed in trust for the recipient of the gift. The premiums you pay are treated as gifts, reducing the amount available of your annual gift exemption. You only need this insurance if tax will be due on the gift. Whole of Life insurance The way whole of life insurance works is this: l You take out a whole-of-life insurance contract (see notes that follow); l On a joint-life, second-death basis (if married/in a civil partnership); l Put the policy in trust. The last step is crucial. When the second person dies, the policy pays out but not into your estate, so there is no Inheritance Tax charged on the proceeds. There have been cases where the adviser has made his money by selling the insurance but failed to organise a trust. The insurance policy proceeds on death are then used by your executors to meet some or all of the IHT liability. Note that the premiums are gifts, so these either need to be within the 3,000 annual exemption; or you need to be able to afford them without running down your savings; or you need to get your children to pay them. If none of these apply, the excess over 3,000 a year is a chargeable lifetime transfer. Keep very good records. In the chapter about trusts we look at periodic and exit changes. Normally the value of an insurance policy is low. However, if death (or terminal illness) occurs shortly before a tenth anniversary, the trust (containing the life policy) will have a value the death benefit. This could lead to some tax being charged at the 6% level (referred to in chapter 2) if the value of the policy exceeds the nil-rate band. Whole of life insurance comes in three varieties guaranteed, balanced and maximum cover. Each is capable of running for life. Under a guaranteed contract the premiums are guaranteed not to rise and the cover not to fall. However, as you are transferring all the risk to the insurer, the insurance company will charge a lot more the premiums could easily be as much as double the cost of a balanced contract. In a balanced cover contract you are taking an investment risk. The premium is split into a savings element and an insurance element. Normally insurance gets costlier as you get older and the savings element builds up and later subsidises the premium. Provided the investment element manages to meet a target set at, say, 6% a year, the premium will not rise during your lifetime. If it beats this target you may find that your cover increases (rather a good idea with IHT) or you might be able to reduce your premium. If investment returns fall short of the target, you may find that premiums rise or the level of cover falls. On a maximum cover basis, all the premium goes into insurance, and none into savings. This is very cheap at first. After, typically, ten years the premiums have to be reviewed. At that time the costs will rise dramatically and the premium may then be unaffordable. This form of cover is really only suitable for use as temporary fix. For example, a couple in their fifties may feel unable to give anything away but don t want to risk a large IHT bill on a premature death. Always shop around for whole of life cover. While many insurers offer the cover, the difference in cost between the cheapest and the average is amazing. Taken over a lifetime, this could run into many thousands of pounds

16 Chapter 10 Annuities Chapter 10 Annuities 10 Annuities An annuity is an annual income, which may be for a fixed period or for life. How much you get for a given purchase price depends on your age, health and how long you want to be sure of payment if you die early. If you buy one which has no guaranteed minimum payment period, it ceases to pay you on death. It is possible to make an immediate Inheritance Tax saving and protect your estate by buying an annuity and using the income to pay for a whole of life insurance policy. The purchase price of the annuity comes out of your taxable estate so you get immediate tax relief (from IHT) at 40% of the purchase price. If you use the income to pay for a whole of life insurance you will often find that the insured sum is much greater than the purchase price of the annuity. This arrangement has solved the IHT at a cost of 100,000, saving 270,000 of tax a profit of 170,000. The big advantage of this scheme is that the purchase price of the annuity comes off the value of your estate immediately while the life insurance pays out to your beneficiaries with no IHT (or other tax). If nothing is done, the beneficiaries get 730,000 ( 1 million 270,000). However, by following this strategy 230,000 is paid by the policy so beneficiaries get 900,000. Example Doris has an estate worth 1 million and an IHT nil-rate band of 325,000. Without action, 675,000 will be taxed at 40% which is 270,000. She buys an annuity of 5,400 (net of income tax) a year for 100,000 which therefore reduces her estate to 900,000. The income buys a whole of life insurance with a death benefit of 230,000 which she puts in trust. She dies soon afterwards. Her IHT on death: Estate value 900,000 Less: nil-rate band ( 325,000 ) Taxable 575,000 Tax at 40% 230,

17 Chapter 11 Trusts Chapter 11 Trusts 11 Trusts Trusts have a long history in England and are said to go back to feudal times. The subject is highly complex and it would need a whole book to explain them in any detail. What follows is hugely simplified to cover the most common planning arrangements. You must not do anything involving a trust without professional advice from a solicitor or financial adviser. In simple terms a trust involves someone giving someone else legal title to something; that person is trusted to hold the asset for beneficiaries. There are three types of trust which are most relevant to IHT Planning l The discretionary trust l The interest-in-possession trust l The bare trust The difference largely rests on whether any particular person has an interest in possession. This means they have a specific income from, or the specific enjoyment of the use of, the trust assets. Before we consider how these fit in with your family, it is worth touching on the basic make-up of a trust. There are three levels of stakeholder in a trust: l The settlor, who settles property into a trust. l The trustees, who look after the property. l The beneficiaries, who are entitled to something from the property (income or capital or both). Since this is open to abuse, you will be charged a lifetime rate of tax of 20% if you give more than the nil-rate band ( 325,000 until 2017/18) to a discretionary trust within a seven-year period. If you die within seven years your estate would pay a further 20%. There is also a periodic charge, every ten years, of 30% of the 20% lifetime Inheritance Tax rate (i.e. 6%). This is charged on the value of the assets in excess of the nil-rate band. This was explained in chapter 2. If money is withdrawn from the trust between the ten year periods, a pro-rata tax charge will be made. This charge is based on the rate of tax at the last ten year charge. If there was no tax on setting up the trust, there is no tax on any withdrawals in the first ten years. Similarly, if there was no charge at the last tenth anniversary no tax will fall due in the next ten years. You can see that if you made the beneficiary a grandchild, the tax would be paid two generations later (depending on the grandchild s own circumstances on death and the tax and rates applying at that time). It is much better to let your children or grandchildren enjoy all your money before giving the government 40%, than letting them enjoy 60% of it and then pay another 40% when they die. Interest in possession trusts A interest in possession trust defines someone s interest in the income from or use of trust assets throughout a period possibly all of their lifetime. Since the beneficiaries effectively own the assets in the sense that they have the benefit of them, they are treated for IHT purposes as if they owned the assets outright. In March 2006 the tax treatment of the different types of trust were brought into line so for IHT planning purposes there is now little difference between them. Discretionary trusts Under a discretionary trust, anyone could be a beneficiary unless you define a list of people who may benefit. How the beneficiaries actually benefit is at the discretion of the trustees. It is very important that the trustees know your wishes. If you set up a discretionary trust, write down your wishes, a letter of wishes, and give it to the trustees. Even knowing your wishes, the trustees are not obliged to follow them. A discretionary trust is quite powerful as in theory you could give away money, saving IHT, while not really giving the money to anyone

18 Chapter 11 Trusts Chapter 12 Planning using investments Bare trusts A bare trust is an arrangement where assets are simply held in someone else s name, but where the beneficiary has an immediate and absolute entitlement to the income and capital. Such trusts are common for minors simply because they cannot legally hold property until they are 18 (sometimes 16 in Scotland). Assets held in a bare trust are not settled property at all for IHT they form part of the beneficiary s estate. Consequently gifts into a bare trust are not chargeable lifetime transfers, they are potentially exempt transfers. The danger with a bare trust is that the beneficiaries cannot be changed. The asset is in the beneficiary s estate for IHT and it is their property in the event of divorce or bankruptcy. There are mechanisms available to imitate a bare trust and restrict an adult s access to capital. A grandparent could set up one of these and then before the child reaches 18 decide when they can have their fund. Now let s put these trusts into context. For the average family, legal costs are going to make setting up and running trusts impractical. We will look at trusts again when we consider insurance and investment-based planning. In those cases there is normally little or no cost of using the trusts. 12 Planning using investments In chapter 11 we looked at ways to delay or avoid tax using trusts. We now look at the use of investment-based plans (usually involving life insurance based plans) to help you cut the Inheritance Tax bill. Loan-based plans Loan-based plans are intended to stop your estate from growing by putting the income from your capital into trust, while leaving the capital available for you to spend. If you lend a sum of money to a trust and the trust puts the cash on deposit, you will always be owed the original sum and run no risk of loss. The interest will belong to the trust. Although the loan value stays in your estate for IHT proposes, the growth (i.e. the interest) is outside your estate from day one. The beneficiaries cannot get at the interest during your lifetime, so you cannot lose out. So for those who can t afford to give away their capital but who could afford to lose the income, this is a possible way to stop the IHT bill getting bigger. A sensible investment for such a trust is an investment bond as the bond avoids the need for a costly trust tax return. By taking advantage of these rules you could structure the arrangement to provide full access at any time to your original investment less any capital already withdrawn while all growth is outside your estate for IHT purposes. A suitable trust would be normally supplied by the investment bond provider at little or no additional cost. There is almost no point in engaging in this sort of planning which seems to benefit mainly people who sell bonds. If you don t need investment income, just give it away using the gift out of income relief and avoid the costs and complexity of a trust

19 Chapter 12 Planning using investments Chapter 12 Planning using investments The Loan trust Loan trust Grow/Investment income Original investment 100,000 IHT falls due on what remains of this part The settlor can take what remains of this part at any time This is free of IHT from day 1 Discounted gift schemes For many people, an income is needed in later life while the capital is not needed. If the income and capital could be separated, and the capital given away but the income kept, this would be ideal for IHT. Unfortunately, as we saw earlier, a gift which is not made fully is a gift with reservation of benefit and fails. A discounted gift scheme gets round these rules by effectively splitting the gift into two quite separate parts. The settlor (the person setting up the trust) carves out rights to an income. Typically this might be achieved by keeping 5% a year for life. The settlor has a life expectancy (which will be calculated by an actuary and confirmed by medical evidence from a doctor) and so a value can be placed on this stream of income. This stream is known as the settlor s reversionary interest. The remainder of the fund is the beneficiaries interest. Provided the settlor lives for 7 years after making the gift, no IHT is due on the death of the settlor. Now here s the clever bit! IHT is measured on the estate at death plus any gifts made in the seven years before death. A gift is measured not by what the recipient gets, but by how much the estate was reduced by the gift. The value of the gift here is the amount put into the trust minus the reversionary interest. (Suppose you had a life expectancy of 8 years and had carved out 5% a year for life. You might argue that the value of this carve-out is 40% i.e. 8 x 5%. So your gift is only worth 60% of its face value for IHT purposes. If you die early only 60% of your gift is taxed.) In this example, the settlor has loaned 100,000 to a trust. Any growth is outside the estate for IHT purposes. The balance of the original investment is always in the settlor s estate. Warning! If the investment falls the trustees can be personally liable for the shortfall. Make sure appropriate steps are in place to cover this possibility

20 Chapter 12 Planning using investments Chapter 12 Planning using investments Example Joe gives away 100,000 into a discounted gift trust, keeping 5% a year for life. Taking into account his life expectancy and age, his interest is valued at 40% or 40,000. He dies the day after making the gift. His estate has the value of the gift added back which is worth 100,000 minus the 40,000 so 60,000 is added back. The 40,000 falls out of account for IHT saving 16,000 immediately. The Discounted gift scheme Discounted gift diagram Grow/Investment income This is free of IHT from day 1 This benefit for early deaths is valuable, but for every earlier-than-average-death there must be a later one so overall this sort of scheme is presumably neutral. This is probably why HM Revenue and Customs do not seem to object to them at present. Their manuals refer to them so they are an accepted part of the tax planning environment. 40% No IHT is due on this part because it has not been engiven away. The settlor expects to get 40% of the gift back in his/her lifetime It is unwise to set up these plans looking for a benefit on premature death as HM Revenue and Customs will investigate every such case. Nevertheless the benefit on an unexpected premature death is considerable. As HMRC will investigate early deaths, it is important to have medical evidence available as to the state of health when the plan is entered into. In other words it is essential to have the discount underwritten at the outset. Be wary of advisers trying to sell this scheme because of the discount (which is just a by product of, and not a reason for, setting up the plan). Also note that these schemes may not be used by the over 85s. Finally the scheme should be approached with great caution. It is irreversible and gifts cannot be made to the beneficiaries before the settlor dies. The income of 5% is fixed for life and could rapidly lose purchasing power to inflation. The settlor can never regain control of their capital so if circumstances change (e.g. going into care) the scheme could cause a great deal of suffering. In most cases there are better alternatives. Note that gifts over the nil-rate band may trigger lifetime tax changes. A diagram of the scheme follows. 60% In this example, the settlor has put 100,000 into trust but wants an income of 5% a year for life. Any growth is outside the estate for IHT purposes

21 Chapter 12 Planning using investments Chapter 12 Planning using investments Flexible reversionary Interest Trusts (also sometimes known as conveyor belt trusts) A small number of sophisticated plans are available which are more flexible than the discounted gift schemes and more effective than the loan trusts. These work by splitting up the trust investments into parcels, say 10 in total. Each year on a specific date, you (the settlor) have the right to one (and one only) of the parcels. The others are out of your reach. Each year you decide whether or not to take none, part or all of your parcel. Anything you do not take is left on the conveyor belt and falls out of reach for another ten years. Next year the conveyor belt moves and another parcel becomes available. This provides great flexibility over the amount of income you can take each year. The whole trust fund is exempt from IHT after 7 years and one day; and all growth is exempt from day one. A further major benefit is that you may make gifts out of the trust at any time and you only have to survive by the balance of the original seven years. For example, if you have it in mind to make a gift to your 16 year old grandson on his 21st birthday, you would have to survive until he was 28 (i.e. 7 years beyond his 21st birthday) for the gift to be IHT free. Using this scheme, you would only have to survive to his 23rd birthday for the gift to be IHT free. At first sight this seems too good to be true and you would think these schemes would fall foul either of Gift with Reservation of Benefit rules or Pre Owned Assets Tax rules. However, the schemes promoters say that they have Counsel s opinion about the validity of their schemes and there are many thousands in existence. A word of warning here, too. Only a minority of advisers are aware of these schemes so always ask about your adviser s experience in this area. At the time of writing there were three providers of these schemes and none distribute directly so you need to find an independent firm to help you. DIAGRAM 1 Flexible discretionary trusts OR You can take this year s maturity or defer it to year 11 (or any year of your choice) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Or you can take part and defer part Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 In this example, the settlor has put 100,000 into trust, choosing to split it into 10 equal annual maturities, each subdivided into segments of 2,000. (Segments must be equal.) Each year one policy matures. Maximum practical amount is equal to IHT nil-rate band. Above this, IHT at 20% is charged