Minimise your IHT liability

Inheritance tax (IHT) has historically been considered a tax on the estates of the wealthy few. But over the past 15 years or so, rising house prices (notwithstanding the housing market correction since 2008) have far outstripped increases in the tax-free allowance, pushing far more 'ordinary' folk into the realm of IHT liability.

The tax-free allowance is commonly known as the nil rate band (NRB). It now stands at £325,000 and will remain at that level until 2015.

However, the rules were changed in 2007 to introduce the transferable NRB for married couples and civil partners, which means when the first partner dies, any unused NRB can be transferred to the surviving partner. Married couples can therefore now have £650,000 of assets before IHT at 40% becomes a potential problem.

The transferable NRB rule has resulted in far fewer estates being liable for IHT: in the 2010/11 tax year only around 16,000 paid tax - less than half the number affected in 2006/07 before the change was introduced. But the fact remains that if your assets, including your house, are worth more than the NRB, your estate may be taxed when you die - unless you take remedial action beforehand.

It's important to remember that IHT is never a problem for the person who has passed away: it's the beneficiaries whose inheritance will be hit by tax and who will have to sort out any complications. Having said that, most people would prefer when they died that their wealth boosted the coffers of their family and close friends rather than HM Revenue & Customs. So what can be done to keep your assets beyond the taxman's long reach?

ASSETS AROUND THE NIL RATE BAND THRESHOLD

If the value of your home and other assets totals around £325,000 (or £650,000 for married couples), the first thing to recognise is that even if your requirements are pretty modest now, you may well need to draw on your assets to pay for additional care as you get older. The priority should therefore be to ensure you have what you'll need looking ahead, rather than to minimise the risk of IHT for your family.

Indeed, says Christine Morris, a financial planner with Informed Choice (South West), it's crucial to assess your health needs at the outset. "If a client is in poor health and subsequently needs residential or nursing care but has given away assets, that could be perceived as deliberate 'asset deprivation' if they are seeking local authority assistance with care funding," she points out.

"We generally put a cash-flow model in place to lay the foundations for planning and see if there's likely to be surplus income available," says Stephen Page, a director of financial planning firm Page Russell. "If people have an index-linked state pension, personal pensions and a decent final salary pension, their income should keep pace with their requirements."

In such circumstances, he continues, the aim is to maintain the level of wealth at below the threshold without impacting on lifestyle, through the use of the various gifting exemptions available.

1. Annual gifting allowance

You're allowed to give away up to £3,000 each tax year - so £6,000 a year for a married couple - to one or more people, without any tax liability at all.

If you didn't use your previous year's allowance you can carry it forward to the current tax year, enabling couples to give away up to £12,000 in the first year they start this regime.

2. Small gift allowance

In addition, unlimited gifts of up to £250 can be made each tax year, though they cannot go to the same people who received the annual £3,000 gift.

3. Gifts out of normal expenditure

An important opportunity is available if you find you have more income than you need in retirement. Provided they don't affect your normal lifestyle, monthly or annual gifts can be made out of regular income, which, as Page observes, "is particularly useful if you have an index-linked pension that will keep pace with inflation".

It's also possible to make exempt gifts to people who are getting married, though these are less significant as regular tax-planning tools. They include up to £5,000 from each parent of the couple; £2,500 from each grandparent or more remote relative; £2,500 from bridegroom to bride (and vice versa) and between civil partners; £1,000 from anyone else.

However, Page cautions against giving away capital that provides you with the income you're reliant on, or might need in the future - again, that's where cash-flow modelling can be a valuable exercise. It's also important to ensure formal records are kept of each gift for the benefit of HMRC: "You need to write formally to each recipient to say that this is an outright gift," he adds.

4. Insuring against a tax charge

Christine Morris makes the point that many of her younger clients, who may have decades of active life ahead of them, are reluctant to start making outright gifts of capital at such an early stage.

"A temporary solution that we have found works well, assuming they are in reasonable heath, is to put in place a whole-of-life plan written in trust for the beneficiaries, which will pay out on the second death." The idea is that the sum assured should at least match the potential IHT charge, so that if you die in the next 10 years the beneficiaries won't have to meet that cost themselves.

Morris explains that if it is written on what is known as maximum basis, which means that the premiums fund the insurance element of the policy mainly and not the investment content, they can be very cheap. "In our experience around £20 a month will provide about £200,000 worth of cover," she remarks.

But under this arrangement, the premiums will be reviewed regularly, rise significantly after 10 years and keep rising as you get older. A longer-term alternative is to go for balanced or standard cover, involving more expensive premiums from the outset but generally no future increases.

In general, it's important to understand that whole-of-life insurance policies do not enable you to avoid tax - merely to pay for it in advance, and by instalments.

5. Untaken pensions

Occasionally, says Page, couples may find they have an unused (deferred) pension pot they don't need to draw on at all for income. In such cases, it's possible to wrap a pension trust around it so that someone other than the spouse can inherit the benefits free of IHT on death.

"Everyone can nominate a beneficiary (usually the spouse) for their unused pension pot, by way of a notification given to the pension fund trustees, but they have discretion as to whom to pay the benefits to. The use of the trust ensures the pension goes to the beneficiaries you intended, and also removes the value of the asset from the joint estate to keep the value on second death below £650,000," he explains.

WEALTHIER INDIVIDUALS

Of course, it makes sense to use the gift exemptions outlined above even if your estate is worth significantly more than the NRB. Other strategies also come into play as you move up the wealth spectrum, though arguably the level at which they may start to kick in is more a reflection of the kind of lifestyle you're leading, your state of health, and how much spare income capacity you have, than the size of your estate.

1. Potentially exempt transfers (PETs)

If there are still unneeded assets sloshing around after you've constructed your cash flow model for the future and the various exempt gifts have been made, one option is simply to give them away to whomever you want. If you do this, they will be treated as potentially exempt transfers, which means you must survive another seven years after making the gift for it to count as entirely outside your estate for IHT purposes.

However, as Stephen Page points out, the risk for people with assets worth around the NRB threshold is that they will find themselves wrongfooted by events - a disabling medical condition requiring some adaptation of their home, say - and subsequently realise they do need a larger capital base through which to boost their income after all.

"I think it's a better idea in this situation to give away a share of the home direct to the children, which means the surviving spouse then has to pay a market rent to them for use of their share of the property. Not only will the gift be outside the estate in seven years' time, but in the meantime the rent paid also amounts to a transfer of income to the kids," says Page.

"Property may be an asset but it brings its own liabilities and expenses - it's better for a retired person to have cash in the bank and less property to worry about."

2. Gift inter vivos insurance

If you make a PET to a friend or family member but there's concern you may not survive the full seven years to ensure full tax exemption, it's possible for the beneficiary (or you, if you're feeling generous) to take out a single-premium decreasing life policy to protect against any potential IHT hit.

The sum assured falls over the seven-year term, mirroring the tapering IHT liability; if you die during that time, the policy pays out a tax-free lump sum to cover whatever's due to HMRC.

3. Discretionary trusts

John Kelly, director of Square One Financial Planning, suggests that if people don't want to make outright PETs - whether because they don't trust the beneficiaries, or are worried about their marriage or business prospects - it's sensible to use a discretionary trust.

Under this arrangement, up to £325,000 of assets can be put into the trust for the beneficiaries without any immediate tax charge. "It will still take seven years before they're outside the estate, but you can retain some control over their management and distribution," says Kelly.

It's also possible to use a flexible reversionary interest trust that enables you or your spouse to receive an income from those assets if necessary at a later date, but with the trust able to make gifts to beneficiaries during your lifetime. By using life insurance products within the trust, it's possible to avoid any tax returns or the payment of any tax by the trustees, so it's often cheaper to do this than use alternatives.

However, Stephen Page is more reluctant to make use of discretionary trusts. "We often find gifts into trusts are made without a full understanding of the process, charges, taxation and trustees duties entailed in setting up and running them," he says.

4. Life company products

If you have assets over the NRB and reasonable health, Christine Morris and John Kelly both favour a life company product called a flexible reversionary trust, such as Canada Life's Wealth Preservation Bond.

"This particular plan is designed to remove capital from your estate after seven years; it removes investment growth from the estate from day one and allows you to receive 'maturities' each year, which can be accepted, deferred or distributed by the trustees," Morris explains. "Gifts can also be made to beneficiaries during your lifetime."

It's a complex product: the policy is structured as a series of single premium life assurance polices, each with a known term but that can be extended.

However, one attraction is that it invests in any unit trust (or you can appoint a discretionary fund manager at little extra cost), which means it can be matched to the individual's risk tolerance. "This, we believe, is quite a significant bonus over other schemes that only allow investment in AIM shares, which tend to be high risk and very volatile," she says.

"Overall, this plan affords good potential to remove capital from the estate after seven years, but gives investors the option to receive maturities income on a yearly basis, therefore building in a degree of flexibility."

There's a £60,000 minimum contribution, and various running fees, including a 1.5% initial charge and a small quarterly administration charge, with fund charges on top as with any other investment.

ABOVE £1 MILLION IN LIQUID ASSETS

Once you move into this realm, financial planners start to consider the various schemes and products that invest in assets qualifying for business property relief (BPR), which means they fall out of your estate after just two years of ownership rather than the usual seven.

Various investments, including partnership interests, agricultural land, forestry, shareholdings in unquoted companies (including AIM) and enterprise investment schemes (EISs), may qualify for BPR. But for financial advisers looking to guide older people who want to preserve their capital and reduce their potential IHT burden, the main options are typically either an EIS or a packaged AIM portfolio.

Remember, these are designed for investors with various other sources of income and capital assets.

Enterprise investment schemes

John Kelly considers EIS schemes to be "an excellent planning tool for wealthier clients", with the tax benefits not only of IHT relief after two years' investment, but also of income tax relief at 30% and capital gains deferral at up to 28%.

"Historically, EISs have been seen as high-risk options, but some providers have focused their efforts on making them less risky for elderly investors," he explains. "With tax relief at up to 98% it's hard to lose. It's an ideal way to unlock investments like property where there is capital gains tax to pay."

Kelly currently likes the Octopus Solar EIS, which invests in five or more solar energy companies and aims for capital preservation above all. He explains that the long-term government tariffs and legislation supporting investors in solar energy make the field a relatively low-risk one.

Moreover, he adds, even if the EIS investment should fail, there is further income tax relief on the 70% capital at stake after the income tax allowance on investments. Some accountants describe this planning as a "no-brainer".

AIM portfolio schemes

Kelly is less enthusiastic about these schemes, which invest in a selection of shares of companies quoted on the AIM and/or PLUS markets, because of their volatility: he points out that not only are they equity investments but they're focused exclusively on small companies which, if the market nosedives, could deliver "great capital loss" and so are inappropriate for elderly people.

Nonetheless, a number of such schemes survive and thrive, including Investec's AIM Portfolio and Close Brothers' Inheritance Tax Service. Both of these focus on very specific types of company from the 1,250 or so listed on AIM.

"A lot of these companies could have moved up but have chosen to remain on the AIM market, whether because they don't want the additional costs of a listing on the main market, or because it's cheaper to take over other businesses on AIM,' says Barry Anysz, divisional director of AIM at Investec. "Some are as big as those in the FTSE 350 index."

Deryck Noble-Nesbitt, who runs Close's IHT Service, points out that AIM companies often started as family businesses and still have a significant family interest; as a result in many cases they are more conservatively managed than their equivalents on the main market. "A classic example is the Shepherd Neame (SHEP) pub chain, which sailed through the financial crisis with no need to refinance," he adds.

Anysz runs a discretionary managed portfolio of 20 to 30 shares from a shortlist of around 50 to 100 AIM companies with market capitalisations of £50 million-plus; he looks for "good cash flow, no borrowings, strong management, liquidity and growth prospects".

"The aim is to preserve capital, produce some capital growth on a two to five-year view, and diversify risk for investors, but they have to be comfortable with market falls in the short term because that happens on AIM," adds Noble-Nesbitt.

Both AIM portfolio services have a minimum £50,000 limit, and Noble-Nesbitt stresses that this should be cash that won't be needed to generate an income in future years, because although it's easy enough to cash in your AIM holdings and withdraw your cash if you need it at a later date, it will fall back into your estate.

BPR schemes

These IHT mitigation schemes - available from providers including Alpha Real Capital and Octopus - have the same tax treatment as AIM portfolio services (so shares fall out of your estate after two years' ownership), but without the same risk of volatility.

They generally hold unquoted shares in businesses that are unexciting but reliable, including farming, forestry, housebuilding and commercial storage. Octopus Inheritance Tax Service accepts investments of £25,000 upwards; to invest in Alpha Real Capital's CTC scheme you need at least £100,000.

How tenancy in common lets you pass on your share

Stephen Page emphasises the importance for couples around the nil rate band threshold of ensuring they own their property as tenants in common (so each owns a defined share of the home - not necessarily half), rather than joint tenants (where they would both effectively own 100% and the second person to die is the sole owner of the entire home).

"Each partner can then gift their share of the property to, say, their children; the surviving partner will continue to live in it on the first partner's death, and the second share passes to the children on the second death," he says.

The main attraction of tenancy in common is it helps avoid having to sell your home to fund long-term care. Each partner owns only part of the property and can leave their share to whomever they like in their will; so if half the home passes to the children on the death of the first partner, or is placed into a trust on their behalf, then at a later stage, if the survivor needs nursing care, the whole home may be disregarded when the local authority makes its calculations.

But it's not a move to make at the last minute. "If you set up the tenancy in common within a couple of years of a long-term care fees liability, the authority could well view it as a deliberate step to reduce your assets," warns Page.

The long arm of HMRC

Ever wondered just how the taxman would find out if you were making "non-normal" gifts from your income? Probably not, but as Wendy Walton, a member of the UK technical committee of the Society of Trust and Estate Practitioners (STEP), explains, it's basically a matter of HMRC scrutinising the bank statements of the person who has died.

"HMRC can and does call for bank statements for the years prior to death, to analyse large transactions where it suspects that non-normal gifts may have taken place. Bank information will often show to whom the amounts have been paid and HMRC may assume that these are gifts of capital unless other evidence can be supplied to show that they were not."

She stresses the importance of regular documentation if you are making regular gifts out of excess income, to ensure there's a record of the amount and nature of the funds gifted and your intention to make regular gifts, should HMRC start asking questions after your death.

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