An Introduction to Inheritance Tax

A client of mine who has been a sole trader for many years and will start to wind down his business activities soon. His partner worked full-time until five years ago and will be able to take her pension shortly.

My client has two residential properties purchased many years ago that are expected to have large capital gains of around ￡150,000 and ￡125,000. More recently the pair purchased a residential apartment which cost ￡110,000. It is now worth ￡130,000. The two set up a property company in 2019, each owning 50% of the shares. They loaned the company the funds which it used to purchase a cottage for ￡125,000 that is now worth ￡140,000.

The two are in their early sixties. Their main residence is worth around ￡695,000. There are no mortgages on any of the properties.

They have two adult children.

Background to Inheritance Tax

Nil Rate Band

Everyone is entitled to a “nil rate band” (“NRB”) which is the amount of an individual’s estate that is exempt from IHT. For married couples and civil partnerships any unused nil rate band is automatically transferred to their surviving spouse on the death of the first spouse. Broadly speaking this means that you have 2 nil rate bands in your ‘combined estate.’ The NRB is currently ￡325,000 and this means that your combined estate can benefit from the first ￡650,000 being exempt from IHT.

Residential Nil Rate Band

In addition to the NRB, the residential nil rate band (RNRB) of ￡175,000 is available where an individual leaves their home to their children or other direct descendants on death. Any unused RNRB can be transferred to a surviving spouse or civil partner in the same way as the NRB. A combined estate could therefore benefit from having the first ￡1,000,000 exempt from IHT, by utilising both the current NRB and RNRB.

It is also possible to retain the RNRB should you move to a home with a lower value on or after 8 July 2015 and the former home would have qualified for the RNRB. Should you consider this in the future we should discuss the matter in more detail.

Be aware that there is a clawback of the RNRB of ￡1 for every ￡2 where the combined estate is more than ￡2m. A gift of assets prior to the second death can mitigate or even eliminate this clawback.

Potentially Exempt Transfers

Potentially exempt transfers (“PETs”) are gifts of property to another individual which would otherwise be part of their estate on death. Transfers to certain trusts for the disabled or for bereaved minors also qualify as PETs. A gift of an asset made seven years or more prior to the death of the transferor will not form part of the estate and not be subject to IHT.

Should the death of the transferor be within 7 years the value is reduced by taper relief.

IMPORTANT: A PET can be taxed where it is brought back into the estate. For example, you make a gift of ￡400,000 to your children and then pass away 4 years later. If you have made no other PETs or CLTs (explained later) then this would be the first part of your estate charged to IHT.

Chargeable Lifetime Transfers

Chargeable lifetime transfers (“CLTs”) are transfers of value which are not exempt or Potentially Exempt Transfers (PETs). CLTs mainly consist of transfers to Trusts. CLTs are charged to IHT immediately at the lifetime rate of 20% (half of the death rate) and all CLTs in the previous 7 years are accumulated before deducting the NRB for IHT.

CLTs can be useful when transferring assets to a trust with a value of less than the nil rate band, which is currently ￡325,000.

Interaction between Inheritance Tax and Capital Gains Tax?

When assets are sold at a profit the gain is usually subjected to capital gains tax (“CGT”). This also applies to gifts of assets, sometimes referred to as “pregnant assets.” For example, if you were to make a gift of an asset, not covered by a relief, that has a market value of ￡300,000 and originally cost ￡180,000 then you will be charged to CGT on the ￡120,000 gain. The only situations where this does not apply are gifts between spouses and gifts immediately chargeable to IHT, such as CLTs mentioned above.

Mitigating Inheritance Tax

1. Invest in assets that qualify for Business Property Relief

Business Property Relief (“BPR”) is available to individuals or partners of unincorporated businesses and to shareholders of unquoted trading companies. Companies registered on the Alternative Investment Market (“AIM”) are unquoted trading companies. In addition to a holding of shares there are several investment funds that invest in AIM listed shares and they can anticipate projected returns of around 1% - 2%.?Whilst this seems little better than returns on bank accounts the added incentive here is that BPR could save 40% IHT on the value of the investment. Whilst this is of no direct benefit to you, your children and grandchildren could see a huge benefit.

A financial advisor or stockbroker will be able to advise you as to available businesses or qualifying investment funds in which to invest. The income can be rolled up into the investment increasing the amount that could potentially escape a charge to IHT. The advantage of this arrangement is that the investment will escape a charge to IHT after 2 years and if it is done in joint names or if it passes to the surviving spouse on the first death the “clock” is not reset, and it will still become free from IHT after 2 years from the investment date.

2. Transfers into a Discretionary Trust

Another option to consider is transferring assets into a Discretionary Trust. This will be a CLT and if the total transfers are less than the NRB (￡650,000 combined) there will be no charge to IHT. The important issue here is that the CLT reduces your available nil rate band in respect of IHT for 7 years but should you both survive for 7 years following the transfer into the Trust the nil rate band will be free of this reduction.

There is a 10-year anniversary charge on the Trust where the value of the trust exceeds the inheritance tax threshold.

Any capital gains on assets transferred, such as your shares, can be held over under s.260 TCGA 1992 as the transfer is immediately chargeable to IHT but the gain will still be taxed when the assets are sold.?

There will be additional costs of the setting up of a discretionary trust through a solicitor and the annual professional fees for preparing and submitting Trust tax returns.

3. Gifts of assets

The simplest method of reducing your wealth is to give some of it away. Whilst charitable gifts reduce your taxable estate immediately, gifts to family and friends are PETs and only become completely free from IHT 7 years from the gift. However, this still presents an IHT mitigation opportunity. If you have opted to take advantage of the planning opportunities that utilise your NRB then PETs start to reduce the IHT liability from the 3rd anniversary of the gift as taper relief applies (see PETs above).

You must be wary that gifts of assets are transferred at market value and capital gains tax may be payable.

Other Ways of Mitigating IHT

1. Annual Exemption

Both of you are entitled to an IHT annual exemption of ￡3,000. Where the annual exemption is not fully utilised, the balance can be carried forward to the following year, but only to that year. If you didn’t utilise the annual exemption for 2020-21 then you can each have ￡6,000 to utilise in 2021-22.

2. Small Gifts Exemption

The small gifts exemption applies to gifts to the same person up to a total of ￡250 per fiscal year. This is in addition to the annual exemption and the gift must be outright and includes gifts for birthdays and Christmas.

3. Wedding Gifts

Gifts in consideration of a marriage or civil partnership by any one transferor (husband and wife are treated separately) are exempt from IHT subject to the following limits:

• ￡5,000 by a parent of either party to the marriage or civil partnership
• ￡2,500 by one party of the marriage or civil partnership to the other or by a grandparent or remoter ancestor
• ￡1,000 in any other case

4.?Normal Expenditure Out of Income

A transfer of value during lifetime is exempt if it is shown:

• That it was made as part of the normal (i.e. typical or habitual) expenditure; and
• That (taking one year with another) it was made out of their income; and
• That, after allowing for all transfers of value forming part of their normal expenditure, you are left with sufficient income to maintain your usual standard of living.

These smaller exemptions can prove quite useful to establish that gifts to children, grandchildren and possibly friends are not PET’s but exempt transfers. For example, birthday and Christmas gifts could easily be established to be normal expenditure out of income and you could then use the small gifts exemption to provide unusual one-off gifts.

Tax Planning

1. Interest on the Directors Loan

My clients loaned the company the funds to purchase the cottage which is repayable on demand. Interest can be charged to the company for the use of the money, and it can be tax efficient to do so. Currently, in the right circumstances, a basic rate taxpayer can receive up to ￡1,000 or even ￡6,000 of interest tax free. This sum includes all interest such as bank interest on savings and interest received on loans you have made. Any interest paid by a company must have basic rate income tax deducted and paid over to HMRC using the CT-61 procedure.

2. Transfer of Shares in the Company

The company transfers the shares in the company to the children, so they own 50% each. This way the future increase in the value of the company, resulting from profits and the increasing value of the cottage will belong to the children and not form part of my client’s estate for IHT. The value of the company is the market value of the property plus any cash and other assets less the liabilities, including the loan to the couple. This is less than the CGT annual exemptions for my clients so there is no CGT liability.

3. Transfer Apartment into the Company

At this point, my clients no longer own the shares in the company but are still connected to the company. This is because the shares are owned by their children so the transfer will be deemed to take place at market value. This is the case regardless of any sums of money transferred or other consideration.

Based on the apartment’s value of ￡130,000 and cost of ￡110,000 the total capital gain will be ￡20,000, and as the apartment is jointly owned the capital gain will be ￡10,000 each. As the transfer to the company occurs in a subsequent tax year to the transfer of the shares the capital gain on the transfer of the apartment will again be covered by the CGT annual exemption.

The only issue here is Stamp Duty Land Tax (“SDLT”). The transfer of the apartment into the company will be subject to SDLT at 3%, ￡3,900.00

The apartment could also be transferred into the company in exchange for a further loan and additional interest could be charged as noted above. However, the main objective is to reduce the IHT liability so a loan was not taken. The gift is a PET for IHT purposes but if the couple live for 7 years, the IHT saving would be ￡64,000 based on the current market values and outstanding loan ([￡270,000 - ￡110,000] x 40%). This IHT saving will increase as the market values rise and the loan is repaid to H&W.

There is a downside. The couple will no longer own the apartment or the company, their children will. As shareholders, the children can sell the company’s properties, although they will have to repay any outstanding loans to the couple first.

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Further tax planning

There is further tax planning for my clients to consider in the future as their circumstance and tax rules change, such as:

• Transferring other properties to joint ownership to reduce income tax liabilities, particularly when my client ceases working
• Gift other assets to children
• Selling assets subject to IHT and acquiring assets that qualify for a relief such as BPR
• Use of discretionary trusts
• Review Wills again

?If you're considering what the best course for your specific needs are, get in touch for more tailored advice on inheritance tax.