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Understanding Inheritance Tax and Nil Rate Band Discretionary Trusts

On death a person's estate is made up of everything they own. When a person dies and they have joint assets the assets go to the other joint beneficiary outside the Will but are still part of the estate.

The rest of what the deceased owns individually is distributed by the Executor in line with the person's last will and testament. Assets passed to a married partner are inheritance tax free (inter-spouse transfer). Any assets not transferred to the surviving spouse and above the nil rate band will be subject to a charge of 40p in the pound. Traditionally married couples had mirror wills bequeathing everything to the surviving spouse and inheritance tax was rarely an issue.

With the recent boom in house prices, which have doubled in the last ten years whilst the Nil Rate Band has only risen by 75%. It was recently reported that the average price of a house in England was now over £200,000 and 8.2 million people or 34% of homeowners were above the nil rate band. Inheritance Tax is now no longer a problem to just the super rich.

The nil rate band

The nil rate band is the level at which you start to pay inheritance tax and the level is currently £325,000 (April 2016). Inheritance tax is levied at 40%. So if your estate is worth £375,000 and you leave it to your children they will have to pay (£375,000-£325,000) x 40%= £20,000 in inheritance tax.

Changes announced by the Chancellor in his Pre Budget Report on Tuesday 9th October 2007, make changes to the way that Inheritance Tax (IHT) is charged.

The first point to make is that the IHT allowance has NOT been increased. The changes simply allow couples to use both of their allowances. They have always been able to do this through proper Will planning – so the Chancellor is giving nothing away and the only people to gain are those who fail to plan.

Case Study

Mr Smith died in October 2006 when the NRB threshold was £250,000. He made a Will leaving all of his estate to his wife, Mrs Smith died on 19th January 2008 leaving an estate in her own right of £300,000, plus the estate that she inherited from her husband of £250,000, which has now grown to £300,000. Now her estate is valued at £600,000.

Under the pre October 2007 rules, Mrs Smith's estate would have qualified for her NRB allowance of £300,000, but the balance of £300,000 from her husband's estate would have attracted IHT at 40% ie £120,000.

Under the post October 2007 rules, because Mr Jones did not make use of his NRB allowance (as the gift in his Will to his wife was exempt from IHT anyway) Mrs Smith's estate will now be treated differently. She will be able to claim an uplift on her allowance of the percentage amount of Mr Smith's unused NRB which, in this case, will be 100%. So Mrs Smith's estate will enjoy an increase in the IHT threshold from £300,000 to £600,000 and therefore no tax will be paid.

Inheritance Tax Planning

What exemptions are available?

A number of exemptions and reliefs are available to reduce the impact of Inheritance Tax. Exemptions include:

  • unlimited transfers between spouses (and civil partners once legislation concerning tax is introduced), except where the donor is UK domiciled but the recipient is non-UK domiciled. In such cases the exemption limit is £55,000
  • 'potentially exempt transfers' (PETs), being lifetime gifts to individuals and certain trusts, where the donor has retained no benefit from the gift. These are not chargeable if the donor survives seven years from making the gift
  • gifts to charities, heritage bodies, political parties
  • gifts out of surplus income
  • gifts on marriage (within set limits)
  • the first £3,000 of lifetime gifts in any tax year
  • small gifts (£250 or less to each individual).

What tax reliefs are available?

There are two principal reliefs from inheritance tax, namely: i) business property relief ii) agricultural property relief.

Both types, subject to certain ownership conditions, operate by reducing the chargeable value of qualifying assets. The reductions are as follows:

  • 100% for business interests, and with effect from 6 April 1996 all shareholdings in qualifying unquoted companies (including those listed on the Alternative Investment Market (AIM))
  • 50% for control holdings of shares in qualifying quoted companies
  • 50% for land, buildings and certain other assets used in a business controlled by the transferor
  • 100% for interests in agricultural land, including certain tenancies which commenced after 31 August 1995
  • 50% for most other tenanted agricultural land.

The effect of these reliefs is to remove many business interests and farms from the charge to Inheritance Tax.

What are the key planning points?

  • ensure that maximum use is made of all exemptions and reliefs (eg £3,000 exemption per tax year & marriage gifts)
  • try to use the nil rate band in full by making chargeable lifetime transfers of £325,000, and PETs of larger amounts. These will fall out of account after seven years
  • try to avoid gifting assets qualifying for 100% business or agricultural relief to exempt beneficiaries (eg spouses) Instead, give non-qualifying assets to exempt beneficiaries, and qualifying assets to non-exempt beneficiaries. CONSIDER USING A DISCRETIONARY TRUST.
  • consider the use of insurance to pay for the Inheritance Tax liability.
  • Insurance policies can be payable outside the estate.

PROPOSED PRINCIPAL RESIDENCE RELIEF

The changes would apply to Individuals with direct descendants who have an estate (including a main residence) with total assets above the Inheritance Tax (IHT) threshold (or nil-rate band) of £325,000 and personal representatives of deceased persons. The estate must be below £2m.

This measure will reduce the burden of IHT for most families by making it easier to pass on the family home to direct descendants without a tax charge.This measure introduces an additional nil-rate band when a residence is passed on death to a direct descendant, (includes step-children). At the moment it is considered that Discretionary trusts will not meet the requirements for the proposed changes.

This will be:

  • £100,000 in 2017 to 2018
  • £125,000 in 2018 to 2019
  • £150,000 in 2019 to 2020
  • £175,000 in 2020 to 2021

It will then increase in line with Consumer Prices Index (CPI) from 2021 to 2022 onwards. Any unused nil-rate band will be able to be transferred to a surviving spouse or civil partner.

The additional nil-rate band will also be available when a person downsizes or ceases to own a home on or after 8 July 2015 and assets of an equivalent value, up to the value of the additional nil-rate band, are passed on death to direct descendants.

We will see what happens in 2017!