The only 3 ways to avoid Inheritance Tax
Inheritance Tax can be a complex and confusing matter for most people. For this reason, we have prepared a video about the three main categories which cover various strategies of inheritance tax planning. Those who would prefer to read the information can follow on article below which has been written based on this video content.
1. Utilising IHT Allowances (sometimes called exemptions)
Working on the assumption that you’re UK domiciled, you will be entitled to the following allowances automatically:
Nil Rate Band
This is an allowance of currently £325,000 which everyone gets if they are a UK resident and UK domicile. Effectively, this means that the first £325,000 of your Estate is not taxed, so it is a Nil Rate that is applied to it.
Residence Nil Rate Band
This applies if you own a property which is your main residence when you die. This is a complex piece of registration and only applies only if you gift money to direct descendants or adopted children. This allowance is £175,000 from 6th April 2020.
£3,000 Gift Allowance
A gift of up to £3,000 per year can be made each year without being liable to IHT. In married couples or civil partners, this is an allowance per person so a combined amount of £6,000 a year. Over ten years of gifting in this way, you would have gifted £60,000 meaning a potential IHT saving of £24,000.
This allows you to give a gift of £250 to an unlimited amount of people each year.
2. Gifts out of your Estate
Another route to avoid IHT is to make outright gifts. Now, when we say outright gifts, this means that you cannot retain a benefit. For instance, some people often think that they can gift their house to their children even though the children aren't living there.
However, if you continue to live in their house, you're retaining a benefit, and therefore that wouldn't be allowable for inheritance tax purposes. In actuality, it would make matters worse as you would be liable for capital gains tax on the gain of the gift.
On death, your Estate is defined as everything you own unless its exempt for inheritance tax.
A direct gift is a gift that you make to your children or somebody else which is over the value of £3,000. Anything over this value is referred to as a Potentially Exempt Transfer(PET).
This means that the gift becomes effective after seven years. So, should you die before the seven years is complete, the gift will fall back into your Estate and still be potentially liable for inheritance tax – Hence the reason for being called a Potentially Exempt Transfer.
There is an issue around this called Taper relief. People often believe that if they make a gift, that Taper Relief will apply after three years. This is incorrect. It is only if the gift exceeds £325,000 (which is the current allowance at this moment in time) that Taper Relief will apply for the excess over the £325,000. If your gift is less than £325,000 Taper Relief will not apply at all.
Gifts into Trusts
The 7-year rule applies in this instance, but this time it is referred to as a Chargeable Lifetime Transfer (CLT). In this case, the 7-year rule still applies, but if you make a gift of over £325,000, there is an immediate IHT bill applied of 20%. For this reason, it is very unlikely we would advise you to make a gift into Trust over £325,000.
Caution needs to be taken when making gifts into Trust – This is quite involved planning and can be quite complex so you should always seek advice. There are a number of elements that need to be taken into consideration.
For example, if you make a gift into Trust and then subsequently make a direct gift later on (say 4 or 5 years later), you will have just activated the 14-year rule. This rule stipulates that the previous gift into Trust is dragged back in. You would, therefore, always make a gift into Trust before you make a gift into a Potentially Exempt Transfer.
Gifts out of normal income
Normal income is anything that is potentially liable for Income Tax – For example, residential property income, pension income, earned income or any other income that is liable to Income Tax. If you are lucky enough to have an income stream which you don't fully need (in other words you are spending a lot less than what your income is), you can make a gift from that normal income. The benefit of this is that it is immediately outside of your inheritance tax.
As an example, we had a client who was a company Director and was receiving more than £100,000 per year from his pension. He was only spending around £50,000 per year, so he decided to give away £50,000 per year using this rule with the benefit of that is that it is immediately outside of his Estate.
Now, this has to be normal, habitual, and you should ensure that the intention around this is carefully documented and signed. Gifts out of income are very useful, but it must be noted that these are to be made out of income and not Capital. The significant benefit here is that it is immediately outside of your Estate.
Gifts to Charities and political parties
Whenever you make a gift to Charity, it is immediately outside of your Estate, there is no waiting for the seven years. If you make a gift to Charity within your Will, the gift is deducted before any inheritance tax.
If you gift more than 10% of the value of your Estate, then there is a further Tax benefit too. This also includes gifts made to political parties.
3. Buying Exempt Assets
An Exempt Asset is an asset that isn’t liable to inheritance tax if you are holding it on your death. The benefit here is that you only need to hold that asset for two years instead of seven years, as mentioned earlier. So why doesn’t everyone buy exempt assets? First of all, it depends on what it is. One example very rarely used is Agricultural Relief, where you would need to own or own part of a trading farm. There is also Woodland/Forestry Relief, but people very rarely buy farms and woodland.
Business Property Relief
This type of relief does get used a little more frequently. If the owner of a trading company dies and there was a very large inheritance tax bill due, there is a strong likelihood that staff would have to be let go and the company could potentially fold.
While the taxman may collect a lot of inheritance tax, ongoing Corporation Tax or Income Tax would no longer be received as all of those people may potentially be made redundant. Therefore, the government provide this relief for trading companies.
If you invest in small trading companies, then after two years, the value of that asset is outside of your Estate. Bear in mind, this must be a trading company, not an investment company, and you must own it when you die.
For instance, you can’t put money into buying a number of buy-to-let properties or holiday let companies and then expect that to get Business Property Relief. That company would be deemed an investment company rather than a trading company, meaning this rule wouldn’t apply and IHT would be payable on the full value of that company. If, however, you had a company which developed property because you were a builder of some sort, then that would be considered a trading company.
Alternative Investment Market (AIM) Stocks
Another option is to invest in these mid-sized companies which aren't on the full Stock Exchange. It is important to bear in mind that the government could at any point recognise that particular Stock Exchange, and therefore that methodology of mitigating tax could fail.
The more significant issue here is that these stocks are incredibly volatile, and one could lose a considerable percentage of one's investment. So although you've only got a two-year timeframe for Business Property Relief to apply, there is quite a big risk in terms of investment risk depending on what you invest in.
This is something usually arranged through financial advisors and independent financial advisors. This allows you to purchase plans set up by different companies which have Business Property Relief applied meaning you can spread your investment over a range of different companies.
This isn’t an area you should go into without getting experienced advice because the devil is in the detail with these plans. They are regarded as quite high risk because you are investing in small and individual companies.
EIS / SEIS Investments
Now, these are particular types of investment for companies that qualify for EIS, and you get additional tax allowances for income tax on capital gains tax. For some high net worth individuals, they are extremely tax effective . Once gain, we strongly suggest to take advice on this as these can be fraught in terms of the investment risk.
Final Word about ways to avoid Inheritance Tax
People often ask if they can use insurance – The insurance doesn’t avoid the IHT, it simply pays the Tax. It is still a useful route for planning but not necessarily avoiding the tax. And quite an expensive methodology that is nowhere near as effective as using some of the IHT plans we have covered in the above three areas.