Inheritance Tax Examples

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    Business in Wills
    Business in Wills

    Inheritance Tax

    As a Professional Will Writer we need to look at inheritance tax and ensure we fully understand how this should be applied in order to establish if a client has a potential tax liability. This means we need to have a basic understanding of the following to ensure we give the correct advice to fit the client’s circumstances.

    We need to ask: does a client potentially face an inheritance charge ? If they do we must ensure we can calculate the inheritance tax charge correct and finally see if any reliefs are available to the client and their estate.

    The starting point is to remember the current inheritance tax threshold (‘Nil Rate Band’) is £325,000. Therefore if an estate is under this threshold then there will be no tax payable on death. If a client is above the allowance then there may be other factors which we will examine in this paper that need to be taken into consideration in order to mitigate or eliminate any IHT liability.

    If the client is over the inheritance tax threshold a charge at death may occur. This tax is referred to as the ‘death rate/tax’ which is currently charged at 40% on anything which is over the threshold amount. An example is illustrated below:

    ‘Wally the Will Writer visits Richard; an elderly gentleman who owns a house worth £250,000 and a further £200,000 in cash and bonds.
     
    The estate is valued at a total of £450,000. Wally calculates Richard’s potential tax liability as:–

    1) £325,000. @  0%  =  Nil
    2) £125,000. @ 40% =  50,000.

    Therefore the tax liability in this case is £50,000. It may be the case that Richard is a widower. If this is the case, then on Richard’s death he may be entitled to claim any unused allowance from his deceased spouse or civil partner (CP). The surviving spouse or CP would have access to their deceased partners Nil Rate Band uplift or what is commonly known as the Transferable Nil Rate Band’ (TNRB).

    The TNRB came into place in October 2007 and allows the executors of the second spouse or CP to claim the percentage of the unused NRB from the first to die and apply it to second spouse’s or CP’s estate. The TNRB can still be claimed even if the first spouse or civil partner died before it was introduced.

    Again apply this to our case.

    ‘Wally asks Richard if he was ever married. Richard answers he was married and his wife died in June 2007. This prompts Wally to ask the question what happened in her will, to which Richard replies the majority was left to me but she did give our son a gift of £150,000.
     
    Wally being a good estate planner knows that in 2007 the Nil Rate Band was £300,000  and that as Richard’s late spouse used 50% of this by making a £150,000 cash gift. Richard is able to claim an uplift of the remaining 50%. The TNRB is calculated as a percentage therefore Richard can claim 50% of the NRB at the date of his death.

    Wally now applies this to Richard’s current situation by adding the current NRB and half of the unused uplift from his late wife which would give him a ‘Transferable Nil Rate Band’ of £487,500.

    This figure is worked out as follows:- Richard’s has his NRB of £325,000, plus the unused percentage of his wife’s NRB which is 50%. £325,000 x 50% = £162,500 which is the amount in pounds that can be transferred from his late wife. This gives Richard’s estate a total of £487,500 before any inheritance will be payable.

    Applying this to Richard’s estate means there will be no tax to pay on his death as his estate of £450,000 is below the TNRB.

    This problem shows how important it is to analyse the client’s situation and to ask questions which we may not consider relevant or too personal to ask, however by doing so we have reduced Richard’s IHT problem from £50,000 to nothing.

    When structuring a will or making lifetime gifts there are a number of exemptions which need to be considered as they can be applicable in reducing or eliminating IHT. The following are types of gift that are exempt for inheritance tax purposes:

    a) Any property given to a spouse or civil partner (which will benefit from the spouse/civil partner exemption) .
    b) Gifts to charities and political parties will qualify for exemption .
    c) Small gifts which do not exceed £250 to an individual, remember this cannot be given/gifted to a trust .
    d) Transfers of £3,000 per annum, but remember the deceased can carry an unused allowance forward from the previous year .
    e) Gifts made in consideration of marriage – please remember there are different classes of givers and some classes will be allowed to make larger gifts tax free then others. The key for this to be a successful exempt transfer is that the marriage must take place .
    f) Normal expenditure out of income: if claimed (remember this is not given automatically), this exemption applies only to a gift of cash:
    1) Is part of the normal expenditure of the donor;
    2) Taking one with another, is made out of income; and
    3) After other such gifts, leaves the donor with sufficient income to maintain his usual standard of living.

    It is possible when planning a client’s estate that all the above should be considered in aiding the client in mitigating their tax liability by using the allowances which are available to them. Let’s consider this in an example.

    Wally visits Richard (48) who is a divorcee, in good health, with an estate of £400,000. Richard wants to leave all of his estate to his two children. And he wishes to tax mitigate and avoid as much of any potential tax liability he can.

    Richard states that he does not need all of his cash but wants to keep control of his assets while he is still young. Wally advises it would be wise to place his annual IHT allowance into a pilot trust. Wally suggests if Richard places £3,000 each year into trust for the benefit of his children and grandchildren this would, in time, reduce his estate for inheritance tax.

    An example would be if Richard did this every year for 10 years he would decrease his estate by £30,000 and if he did this for twenty years this would reduce the estate by £60,000.

    The rest of his money will be dealt with in his will. If Richard uses his allowances effectively in this way, and lives to the age of 68 he would have reduced his estate by £60,000 and not wasted his annual allowances.

    The other fundamental part which we need to consider when we plan a client’s estate is to ask whether the testator has made any lifetime gifts as they will affect how you structure the will. Inheritance tax is not just payable on death but can also come into effect in life if an individual makes a gift to either an individual or a trust, as we will see below.

    These types of gifts come in two forms, the first is known as a ‘Potentially Exempt Transfer’ or a ‘PET’ . These are gifts made to an individual and do not usually attract an inheritance tax liability in life.

    These types of gifts can be limitless as they are not restricted in value. An example; ‘Richard gives to Tom a gift of £1,000,000 on his birthday’. This would not attract any inheritance tax when the gift is made even though it is above Richard’s NRB. Providing Richard survives the required time period of seven years there will be no inheritance tax at all on the value of gift (the time period will be discussed later in this paper).

    The following are seen to be Potentially Exempt Transfers:

    a) Gifts to other individuals, provided the donee’s estate is increased or the property transferred becomes comprised in his estate ,
    b) Transfers to trustees of a trust which is established for a disabled beneficiary ,
    c) Transfers made on or after 22nd of March 2006 to trustees of a bereaved minor’s  trust  on the ending of an ‘immediate post death interest’.

    Some further transfers to trustees made before 22nd of March 2006 are also deemed to be classed as PETs:

    d) Transfers to the trustees of an interest in possession settlement because the estate of the beneficiary with the life interest includes the property in which that interest subsists, i.e. the settled property .
    e) Transfers to the trustees of an accumulation and maintenance trust .

    The second type of gift which we will consider is known as a ‘Lifetime Chargeable Transfer’  or an LCT (sometimes known as a Chargeable Life Transfers or Chargeable Transfers). Unlike the above, these are gifts which are given to a trust and will attract an instant IHT charge if the amount gifted to the trust is over the settlor’s available NRB.

    A lifetime chargeable transfer is a transfer from an individual, during their lifetime, to any trust which does not fall into any category outlined in point’s b, c, d or e above.

    There will be a tax liability if these gifts into trust exceed the NRB and HMRC will require a payment. This payment is referred to as the lifetime rate/tax and is charged at half the death rate. As the death rate is 40%, the lifetime rate is 20% and is charged on the value gifted that is in excess of the NRB. Unlike with the gift of a PET, there are strict rules as to what the donor will be required to do on completing such a transfer to make this a tax effective gift.

    The best way to examine this is to consider a practical example:

    Richard gives property with a value of £400,000 during his life to a discretionary trust. This transfer is over Richard’s NRB and he will face a lifetime tax charge of 20% on the amount over the NRB.

    IHT is instantly payable in regards to this transfer and will be applied in the following way:

    The first £325,000. @ 0 % = Nil
    Remaining amount over the NRB £75,000. @ 20% = £15,000.

    The donor (Richard) dies a year and half after making the gift which on death is treated as a failed PET and the following would happen:

    £325,000. @ 0 % = Nil
    £75,000. @ 40 % = £30,000.

    The £15,000 tax bill which has already been settled will be taken of this equation and will leave a tax liability of a further £15,000 which would need to be settled in regards of this gift.

    The next important thing to remember is the effect these types of gifts will have on the estate plan. The will writer needs to remember if such gifts have been made then it will have an impact on the way the will is structured and can have an effect on how the tax is worked out on the client’s estate.

    These gifts need to be considered when preparing the will and the drafter should ensure the will and the testator’s estate are not affected by any lifetime gifts to ensure there are no adverse tax problem.

    Again let’s consider the above in a worked example:

    Richard who is a married man invites Wally the Will Writer to his house to discuss his estate plan. When reviewing Richard’s estate, Wally recommends he gives £300,000 as a lifetime gift into a trust for the benefit of his children to mitigate his tax liability.

    Richard agrees to the gift to the trust and also instructs Wally to leave £200,000 in legacies free of IHT to various beneficiaries in his will, with the residue to his spouse.

    Richard dies a year later.

    The effect of this plan is the LCT now becomes a failed PET and the value of the gift is brought back into his estate, resulting in the LCT using the majority of Richards Nil Rate Band. By leaving £200,000 in cash legacies will also add to this problem as Richard has now exceeded his NRB.

    Wally should have given advice in regards to this potential problem at the initial meeting and what effect this will have on Richard’s spouse, i.e. what she will receive from residue will be reduced now inheritance tax is payable.

    Wally should have advised a solution which uses a good immediate post death interest trust to the spouse and for the cash gifts to be made from this after her death. This would ensure her protection if Richard was to die before the LCT had fallen out of the estate, as the gift to trust would qualify for spousal exemption and there would not be tax issues on first death, as highlighted above.

    After 7 years the gift to the trust will have fallen out of Richard’s estate and he would again benefit from a full NRB of £325,000 (or such higher rate as may be in force at the time). At this stage the Will could be reviewed as the £200,000 gifts could be made on Richard’s death without creating an IHT charge.

    In the above example we can see how using a tax effective plan involving spouse exemption can eliminate any tax liability which may have existed on the death of the donor.

    If a donor dies within three years of making a gift it will mean that the gift is not tax effective and full tax will be chargeable on these gifts.

    A gift will become more tax effective if the donor survives longer than three years as these gifts will then qualify for what is known as ‘Tapering Relief’ . The rules of tapering relief are charged on the following sliding scale:

    a) Transfers within 3-4 years before death; only pay 80% of death charge
    b) Transfers within 4-5 years before death; only pay 60% of death charge
    c) Transfers within 5-6 years before death; only pay 40% of death charge
    d) Transfers within 6-7 years before death; only pay 20% of death charge.

    A common misunderstanding is that taper relief achieves its tax saving by reducing the transfer of value. This is not the case – the value of the gift never changes; only the tax due. The effect of tapering relief is a gradual reduction in the amount of IHT due on gifts made within seven years of death.

    Again let’s illustrate the effect of tapering in an example:
     
    Richard died 6 years and four months after making a transfer of £500,000 to his son Tom.

    The effect of tapering relief is that only 20% of the tax at full death rates is payable.

    Assuming Richard has made no other transfers in his life and his will is tax effective, the following will be applied to this gift.

    £325,000. @ 0 % = Nil
    £175,000. @ 40 % = £70,000
    Apply tapering @20% = £14,000

    The full death rate tax on this gift is £70,000 because the donor has not survived the full seven years however he has survived long enough for tapering to be applied to the gift.

    The tax liability is tapered according to the length of time since Richard made the gift, which is 6-7 years therefore the tax owed will be 20% of £70,000, resulting in only £14,000 needing to be paid.

    Although we should now understand the basics of IHT planning and be aware that we need to look at how an estate is made up, in regards to the value of assets, so we can understand if a tax liability exists or not.

    It is always vital to remember when dealing with assets that are being gifted to individuals, into a trust or through the will that asset evaluations are ascertained to establish what’s known as the ‘Market value’ of the asset being gifted.

    This allows you to paint a complete picture of the estate and provides a true reflection of IHT. If HMRC ever question a transfer they will want to see how this valuation was established therefore by obtaining independent evaluations the donor/settlor will have clear records to prove the valuation was accurate.

    The market value is the price the asset is expected to fetch on the open market if sold that day, but remember the price shall not be reduced on the grounds that the asset is devalued due to a surge on the market of similar types of assets .

    The ‘open market rule’ applies on death, although changes in value of an estate caused by the death can be taken into account . An example which highlights this point is life policies which mature on death are valued at the maturity value (not surrender value). Another example is personal goodwill in a business is usually valued lower as this usually allows for the loss of the individual to the business.

    It is also important to consider the effect which is given from joint ownership and the effect this has on inheritance tax planning. Remember a co-owner of land can discount the value of their respective share to accommodate the fact it may be difficult to sell a partial share of co-owned property; the purchaser will have to occupy the property with the other co-owner so a discount of 10%-15% is normal. Again it is always easier to see this in an example:

    Two sisters Ruth and Eleanor own a house equally. If the open market value of the house is £200,000; an independent purchaser is unlikely to pay £100,000 for Ruth’s half the property as they will have to share its benefits with Eleanor therefore a value may be agreed by the Revenue for a half share at £90,000.

    Where spouses/civil partners are co-owners of land, a discount is not normally available. This is because of the related rules to property which requires each interest to be valued as a proportion of the whole. A valuation of other jointly-owned assets does not attract such a discount. In these cases, the open market value is divided proportionately between the joint owners.

    Conclusion

    We have seen in this paper the importance of understanding how inheritance tax works in ensuring we can plan a tax effective estate by examining if a client has a tax liability and explain to them what can be done to help resolve this problem.

    We have also established how tax works in regards to death rates and what tax is charged on lifetime gifts. This means when we structure a plan for a client who has made large gifts within the last seven years we now know how to apply the tapering system to calculate what potential tax liability the client may face.

    By using these tools we can successfully create a plan which will be robust enough to make a sensible estate plan for any client we meet.

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    Matt Walkden Will Writer

    About Matt Walkden

    I am a Professional Will Writer and I offer a small number of other products that complement my Will Writing such as Lasting Power of Attorneys (LPA’s), Fixed Price Estate Administration, often called Probate and some Property Products such as changing a family home from Joint owners to Tenants in Common.

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