To give or not to give,  that is the question

Broadly, above the IHT-free threshold of GBP 325,000 (the “nil rate band”), IHT on the property of someone on their death can be as much as 40%, with no general exemption for passing assets to children or other family members. An exception to this is the “residence nil rate band” which allows one to leave an extra GBP 175,000 to children or grandchildren if they leave their home to them, subject to set criteria. This is unlike the far more generous spouse exemption which can offer a total exemption from IHT. Any gifts to a qualifying charity are also exempt from inheritance tax.

The critical issues for private client practitioners in the UK are how to plan for this situation effectively, and what are the options available during a client’s lifetime.

Outright gift

A person can give away GBP 3,000 in cash or gifts up to this value each tax year with no potential IHT on death (the “annual exemption”). If you do not use the annual exemption, you may carry this forward one year only, effectively being able to give GBP 6,000 away the following year with no IHT implications. Note: the UK tax year is not a normal calendar year and runs from 06 April to 05 April.

One may also make gifts worth up to GBP 250 per person each tax year to as many people as one wishes; this is known as the “small gift allowance”.

Each tax year, a person may also make gifts “in consideration of” marriage or civil partnership free of IHT. Usually these gifts would need to be made before the wedding or civil partnership takes place. These gifts can be up to GBP 5,000 to a child, GBP 2,500 to a grandchild or great-grandchild, or GBP 1,000 to any other person.

If someone has excess income in a year and can prove that they have enough to meet their usual living costs, they may make regular gifts to another person from the excess income not subject to IHT. These are known as “normal expenditure out of income”. There is no limit on the value of these gifts, which can be a valuable way to move assets out of your estate for inheritance tax purposes and pass them on to the next generation.

For those with shares in a family businesses, an important exemption is “business relief”. Provided the business or asset was owned by the donor two years before making the gift, full IHT relief is available on a trading business, interest in a business, or shares in an unlisted company. Fifty percent IHT relief is available on shares controlling more than 50% of the voting rights in a listed company or land, buildings or machinery owned by the deceased and used in a business they were a partner in or controlled, or used in the business and held in a trust that it has the right to benefit from.

There is a similar exemption for qualifying agricultural property (at either 100% or 50% IHT relief depending on the type of property) where the property was owned and occupied for agricultural purposes immediately before its transfer; for two years if occupied by the owner, a company controlled by the owner or their spouse or civil partner, and seven years if occupied by someone else.

Outside the above allowances, anything a person gives away that is not to a spouse or charity will be classed as a potentially exempt transfer (PET). Generally, no IHT is due on any gifts one makes if they survive making them by seven years. However, if a person does die within the seven years, taper relief will be available to reduce the IHT due, which kicks in three to four years between the date of the gift and death.

One potential IHT trap to watch out for is the “gift with a reservation of benefit” which is targeted at those who make a gift which would technically be a PET but for the fact that the donor has reserved a benefit. This classically catches the parent who wishes to make a gift of their family home to their child and to take it outside their estate for inheritance tax purposes whilst still living in it. The only way around this would be to pay the child a proper market rent thereby negating any benefit in continuing to live there. This could also be an effective way to reduce the parent’s taxable estate but they need to have sufficient resources to fund this.

Trusts and family investment companies

The above is all very well but what about those who are reluctant to pass significant wealth outright to their children during their lifetime?

The UK has long recognised the value in establishing trusts to pass assets on, but within a protective environment safe from divorce, creditors, and even the beneficiaries themselves if the trustees have full discretionary powers of appointment.

However, since 2006, most trusts are now within the “relevant property regime”, and there are limited ways for someone to create or settle a trust (known as a “settlor”) and place assets into such a trust without incurring an immediate 20% IHT entry charge.

Some of the above exemptions can be used to place assets into trust without an entry charge, e.g. normal expenditure out of income and business and agricultural property. One may also settle the GBP 325,000 nil rate band into a trust. An individual could do the same thing again every seven years, subject to any other lifetime gifts made in that time.

Once assets are safely in a trust, they are outside the settlor’s estate for IHT although the trusts themselves will attract anniversary charges every ten years, entry charges (subject to the above), and exit charges of no more than 6% of the value of the assets in trust. Settlors can leave a detailed letter of their wishes with guidance for the trustees, covering when the trustees may consider making capital distributions for instance, but such letters are not legally binding.

For clients who are unfamiliar with trusts these are not always an easy “sell” for practitioners working in this field. An alternative vehicle is the family investment company (FIC) which can be attractive to clients from a corporate or financial background such as private equity. The founder of a FIC can retain control over the assets held by the FIC and can decide how such assets are invested. When the time is right, the founder may decide to pass on control to other family members. The founder will also often have a significant role in deciding which family members benefit from any income generated, and when they receive that income via dividends. There can be a detailed shareholders’ agreement containing some of the founder’s views, including, for example, a requirement for pre-nuptial agreements for the family shareholders.

If there is a cash subscription for shares, the 20% charge which may apply on a transfer of property into a trust would be avoided. If the FIC is funded by way of a loan, the loan will remain in the founder’s estate for IHT purposes. Any gifts to the FIC are likely to trigger 20% inheritance tax payable out of the gift, and further IHT if the donor dies within seven years. However, any increase in the value of the investments is transferred immediately and is outside the founder’s estate. Unlike trusts, there are no anniversary charges or exit charges for FICs.

Spend!

Of course, if the client is unwilling to give away significant sums of cash or property to their family or others during their lifetime, whether outright, in a trust, or via a FIC, then there is another option available – reduce the value of their estate through spending, leading to a lower IHT bill on death. This perhaps is not the most popular option for the client’s family, or even the taxman, but should be acknowledged.

Pensions are usually outside the scope of IHT, and it may be worth considering life insurance as an easy work-around if it is available and affordable.

Ideally a client would consider all of the above options as a means to reduce the IHT burden on their death and provide for their family after they are gone.