Niki Patel of Technical Connection takes a detailed look at the benefits of wills and IHT planning
Turmoil, confusion and uncertainty are just a few of the words that spring to mind when thinking about the government’s ill fated September mini Budget. Interestingly, despite the numerous announcements, an area which has not (at the time of writing) been mentioned is any changes to inheritance tax (IHT).
Benjamin Franklin once said: “Nothing can be said to be certain, except death and taxes.” IHT touches on both.
Since 2009/2010, the nil rate band has been capped at £325,000 and it is expected to remain at that level until at least 2027/2028. Previously, it was generally the case that the nil rate band increased on an annual basis.
In April 2017, we saw the introduction of a residence nil rate band which may help to ease the IHT burden for those who can meet the relevant conditions, although in many cases advice will still be required to ensure wills are drafted properly to make use of the residence nil rate band. It is also important to note that the current residence nil rate band of £175,000 is also frozen until 2027/2028.
Figures produced by HMRC show that IHT receipts during the 2021/2022 tax year were £6.1bn. This was an increase of 14% (£729m) on the 2020/2021 tax year and is the largest single-year rise in IHT receipts since the 2015/2016 tax year, when receipts rose by 22% (£848m).
It is clear that, as a result of the ‘frozen’ nil rate band and residence nil rate band, more and more individuals have been brought into the IHT net in recent years. With this in mind, IHT planning has become increasingly important for many individuals. The planning that individuals can carry out will, of course, depend to a large extent on the nature of the assets they own and on their overall objectives. Regardless of this, individuals ought to seek advice to take maximum advantage of some of the IHT planning opportunities that are available to them.
Use IHT exemptions
The primary starting point for anyone wishing to carry out IHT planning is to use their exemptions. The key is that there are a number of IHT exemptions that individuals can take advantage of. The most common ones are as follows:
Gifts to spouse or civil partner – provided both individuals are UK-domiciled, any transfer of value made during lifetime or on death is exempt without limit from IHT.
Annual exemption – each individual can give away £3,000 each tax year and use the previous tax year’s exemption if not already used. They must, however, use the full current tax year’s exemption first.
Small gifts exemption – up to £250 can be given to any number of individuals. The small gifts exemption cannot, however, be combined with the annual exemption; and if the gift exceeds £250 the small gifts exemption will not apply.
Wedding/civil partnership ceremony gifts – the limit on the size of the gift depends on the relationship of the donor to either one of the couple. A parent can give up to £5,000, a grandparent can give £2,500, either of the couple can give £2,500 to each other and any other person can give £1,000.
Gifts to charities – outright gifts to qualifying charities and charitable trusts are exempt transfers.
Gifts to political parties – gifts to political parties are exempt, provided that the political party at the last general election either: had two MPs elected; or had one MP elected and at least 150,000 votes were given to candidates of that party.
Normal expenditure out of income exemption – gifts can be made from surplus income although the following conditions must be satisfied:
- The gift has to be part of the donor’s normal (i.e. typical or habitual) expenditure.
- The gift was made out of the donor’s after-tax income, taking one year with another.
- The donor must be left with sufficient income to maintain their usual standard of living.
It is vital that individuals keep adequate records regarding any gifts they make, because the executors will need to prove to HMRC that such gifts should be covered by the exemption. Such records can be kept using HMRC’s form IHT403, which enables individuals to make a note of all their income and expenses to determine any surplus income they may have to take advantage of this exemption.
Invest in IHT-free assets
Investing in assets which qualify for business relief (or agricultural relief) could provide individuals with substantial IHT savings.
The maximum relief available for both business relief and agricultural relief is 100% on the value of qualifying assets, which must have been owned for at least two years. For business relief purposes, this broadly means an interest (including a partnership interest) in a trading business as well as holding unquoted trading company shares; and for agricultural relief purposes this means property used for agricultural purposes.
The use of enterprise investment schemes, which broadly involves investing in smaller trading companies, has become popular during recent years. Provided the individual owns unquoted shares in qualifying trading companies for at least two years, these shares would qualify for 100% business relief, thereby reducing the IHT payable on death. However, these types of investment are considered to be higher risk, so individuals would need to consider whether this is an area that is suitable for them, as with any other type of investment.
For some individuals it may be possible to make other lifetime gifts, whether outright to another individual or by executing a trust.
The current regime for outright gifts (including gifts to bare trusts) is favourable, thereby providing scope for lifetime planning. Outright gifts are potentially exempt transfers (PETs) for IHT, meaning that no lifetime tax is payable on the gifted amount, or on any increase in value, if the donor survives for the required seven-year period the gift is free of IHT. Also, there is no restriction on the nature of such gifts or on the amounts that can be gifted. So, provided the donor is in reasonable health and is happy to make such gifts, substantial IHT savings can be made.
In cases where an outright gift is not a suitable option, a trust (other than a bare trust) can be used. Today, most forms of trusts where the donor wishes to maintain control of the assets are taxed as relevant property trusts and so are subject to the IHT discretionary trust tax regime. Because the trust fund does not vest in anyone’s estate for IHT purposes, associated IHT charges apply on creation, when capital is appointed out of the trust and on each ten-year anniversary. These are more commonly known as entry, exit and periodic charges.
By setting up a discretionary trust, the donor would have the option of acting as one of the trustees, which would enable them, along with the other trustees, to ultimately decide when benefits should be appointed to any one of the beneficiaries under the trust. The gift is a chargeable lifetime transfer (CLT) for IHT purposes, meaning that where the transfer of value exceeds the donor’s available nil rate band, IHT at the lifetime rate at 20% (or 25% where the tax is paid by the donor) would be payable on the excess. For these purposes, the available nil rate band is the current nil rate band, now £325,000, reduced by any other chargeable transfers made in the preceding seven years.
Other packaged IHT trust solutions
In addition, to lifetime gifting, there are other planning options that can help individuals mitigate IHT in their lifetime, yet continue to have access to either capital or an income.
For example, a loan plan enables the individual (settlor) to make an interest-free cash loan that is repayable on demand. In most cases, the trustees would invest in a life assurance investment bond and then use the cumulative 5% tax-deferred facility to make loan repayments to the donor as and when funds are required. The IHT benefit of this is that any growth on the original loan is outside of the donor’s estate and they can still have access to the capital loan, which means that the IHT liability on the amount lent is effectively frozen.
Another option is a discounted gift plan. Under this type of arrangement, an individual makes a gift while retaining a right to income under the terms of the trust. The income is usually fixed at outset and payable throughout the donor’s lifetime. An actuarial calculation is carried out, based on the donor’s age and life expectancy, which usually results in the initial gift being discounted. From an IHT perspective, the discount is immediately outside of the taxable estate while the remainder would be a gift that would fall out of account provided the donor (settlor) survives seven years from the date of creating the trust. Again, the trustees would usually invest in a life assurance investment bond and use the 5% tax-deferred facility to make the fixed payments to the donor.
Individuals ought to seek advice to take maximum advantage of some of the IHT planning opportunities that are available to them
These arrangements, along with others, are offered by various providers and the terms of the different products can vary accordingly. It is, therefore, always recommended that individuals seek advice to see which planning vehicle may be appropriate for them.
Deeds of variation
Where assets are inherited, whether under a will or under the intestacy rules, it is possible to redirect the inheritance to achieve an immediate IHT saving by using a deed of variation.
Ordinarily, the inherited assets will accumulate in the taxable estate of the receiving beneficiary, who may not want or need the inheritance. Instead of choosing to make a gift of the inheritance (which would either be treated as a PET or a CLT), it is possible for the receiving beneficiary to take advantage of the deed-of-variation option and achieve an immediate IHT saving on their own estate.
To achieve the desired outcome, the variation must:
- Be in writing – usually by deed;
- Contain a statement that the relevant legislation (s142 Inheritance Tax Act 1984) is intended to apply;
- Be made within two years of death by the person(s) who would have benefited from the original gift;
- Not be for consideration; and
- The property must have been included in the deceased’s estate at the date of death.
The deed can also contain a statement for capital gains tax purposes (s62(6) Taxation of Chargeable Gains Act 1992) where the inherited assets are, for example, shares, because these can be redirected at the date-of-death value rather than the value at the time the deed is executed.
In practice, there is no requirement to vary the destination of the entire amount of the inheritance enabling the receiving beneficiary to choose to vary only part of it. It is possible to direct an amount to an individual or to a trust. The option chosen will, of course, depend on the individual’s specific circumstances taking account of factors such as whether they are wealthy in their own right, whether they are likely to want to retain control and whether they may wish to benefit in future should the need arise.
A variation into a discretionary trust enables the individual to retain access by being named as a beneficiary. They can also maintain control by acting as one of the trustees. This is a viable planning option that does not fall foul of the gift with reservation provisions or pre-owned assets tax – the variation is effectively treated as having been made by the deceased for IHT purposes, provided the necessary conditions are satisfied.
Amanda dies, leaving an inheritance of £300,000 to her son Jamie. After around eight months, Jamie decides to redirect £200,000 into a discretionary trust for the benefit of his grandchildren and two nephews. As the variation is into a discretionary trust, Jamie can also be included as a beneficiary of the trust. He also decides to act as one of the trustees alongside his brother to retain control in terms of deciding when appointments should be made to any of the beneficiaries. From the outset, the whole £200,000 is outside of Jamie’s estate for IHT purposes and with the added benefit of knowing that he could gain access to the funds, via the trustees, if he needed to in the future.
Note that as the variation is made to a discretionary trust, the settlor for IHT purposes would be the deceased, Amanda in this case. However, the settlor for income tax purposes would be Jamie so he would be taxable on any income arising within the trust; and if the trustees invested in a life assurance investment bond, Jamie would also be taxable on any chargeable event gain while he is alive and UK resident. Although, in practice, it is usually more beneficial to assign the bond/segments of the bond directly to an adult beneficiary for them to encash, especially where they would pay less tax than the settlor (Jamie in this case) and/or the trustees.
Insure against the liability
Many individuals, especially those whose wealth is mainly tied up in property, may choose to insure against the potential IHT liability. This can be achieved by taking out a whole-of-life policy written in trust. Provided the premiums are covered by the annual exemption, or the normal expenditure out of income exemption, there would be no transfer of value for IHT on payment of those premiums. As the policy is held in trust, no probate should be required on death of the life/lives assured. This means that there would then be available funds to meet the IHT liability on death.
Research conducted by various professional bodies shows that a large proportion of the UK population has not written a will, regardless of owning property or other assets
Research conducted by various professional bodies shows that a large proportion of the UK population has not written a will, regardless of owning property or other assets. While a will is often used for tax-planning reasons and to protect assets, there are other reasons as to why individuals ought to write a will.
Ensure the will is valid and executors are appointed
The starting point is to ensure that a valid will is in place. Broadly, it must be written by an adult, so aged 18 or over, who is of sound mind. It must be signed and dated in the presence of two adult independent witnesses. So, it cannot be witnessed by anyone who can benefit under the terms of the will.
The executors must be named as they are responsible for dealing with the administration of the estate. This means that they must complete the IHT account, pay any IHT that may be due and apply for probate, if required. Once grant of probate has been received, the executors then have the legal right to deal with the estate – so they would be required to pay any debts, taxes, expenses, etc, and then distribute the assets in accordance with the terms of the will.
Provide funeral instructions and appoint guardians
For many, deciding on what type of funeral they would like will be important. They can include funeral details on the type of service they would like, whether they wish to be cremated or buried and whether they would like certain songs played or readings to be read, within the will. By doing so, family members can follow this guidance, which would help reduce the burden for them. Some individuals may, of course, have taken out a prepaid funeral plan to cover the cost of the funeral.
Those with minor children ought to name who should act as a guardian, otherwise the family courts will decide where the children should go. It is also advisable to consider the ages of such children and what provision is likely to be needed for them. A will can ensure that children will be properly looked after, because funds can be set aside for their benefit – usually by including a trust to that effect in the will.
Also, in cases where there are pets, individuals should consider whether a family member or friend would be prepared to look after them and what provision is needed for them. Again, funds could be set aside to use to look after any pets.
Protecting assets and ensuring the right people benefit
Where an individual dies without having written a will, they are deemed to have died intestate. This means that, in England, their assets are distributed in accordance with the Administration of Estates Act 1925 – broadly it is the law that decides who should inherit their assets and in what proportion.
While the intestacy rules are designed to protect the individual’s family, this can still cause several problems, especially for those in a longstanding relationship who are not married or in a civil partnership. This is because partners have no automatic rights under English law. Equally, for those who are separated but not divorced, their spouse or civil partner would inherit part of their estate on intestacy. Further, if there are no close relatives, assets could pass to distant relatives whom the deceased had no intention of leaving assets to, or, where there are no relatives, assets could pass to the Crown.
Therefore, one of the most important reasons for writing a will is to ensure that assets pass to the intended beneficiaries on death. The will should also specify whether certain individuals should inherit specific assets – for example, particular items of jewellery, paintings, other personal possessions, etc.
Dealing with digital assets
With the growing popularity of social media, it is advisable to include provision for what should happen to any digital assets. It is possible to name a digital executor to manage these assets on death. The will should include information on how such digital assets are handled, for example whether an account should be closed or not and what should happen to any photos and videos.
It is also advisable to ensure that the will is written in a way to maximise tax savings. Prior to the introduction of the transferable nil rate band, in many cases the nil rate band was often wasted on first death by leaving assets to a surviving spouse/civil partner that would otherwise pass exempt.
Many couples now rely on the transferable nil rate band rules to ensure use of the nil rate band on second death. That said, as mentioned above, given that the nil rate band has remained at £325,000 for a long time, for some, making use of the nil rate band on first death ought to be considered. This reduces the value of the estate on second death, which can be beneficial for the purposes of making use of the residence nil rate band and also any growth will be outside of the estate of the second person to die.
The will can therefore be drafted to maximise IHT savings. And for those who wish to leave assets to charity, if 10% or more of the net chargeable estate is left to charity, the rate of IHT payable on the taxable estate is reduced to 36% instead of 40%.
The need to update/review a will
For many, even if they have written a will, ideally it should be reviewed whenever their circumstances change, for example if the individual gets married, divorced, becomes a parent or receives an inheritance.
If they already have a will in place and get married or enter into a civil partnership, the will is automatically revoked, so a new will would need to be made. The same rule, however, does not apply if they get divorced or their civil partnership is dissolved. In that case, anything left to the ex-spouse/ex-civil partner in the will would be dealt with as if they had died on the date that the marriage/civil partnership legally ended. This means that any gifts/assets that may have been left to the ex-spouse/ex-civil partner will no longer pass to them, although the provisions in the rest of the will would usually be valid, so could cause unintended consequences where their circumstances have changed and they wish to redirect assets to other people. Whatever the ex-spouse/ex-civil partner was set to inherit would then be passed on to the next beneficiary who is entitled to it, in line with the terms of the will. If everything had been left to the ex-spouse/ex-civil partner, with no other beneficiaries named, then the estate would be dealt with under the intestacy rules.
So, if a will is not updated to reflect a divorce or the dissolution of a civil partnership, the estate might not pass to the intended beneficiaries. This could also mean that new partners or dependants aren’t provided for.
This article sets out some general IHT planning opportunities individuals could consider, as well as the importance of writing and reviewing their will. As always, it is key to seek advice prior to implementing such planning to ensure it is line with the individual’s overall objectives.
Niki Patel is a tax and trust specialist at Technical Connection