Register free for our breaking news email alerts with analysis and cutting edge commentary from our award winning team. Registration only takes a minute.

Top 10 estate planning tips to cut IHT burden

Ten tips on how to reduce your clients’ IHT burden and put safeguards in place to avoid HMRC raising queries after their death, by Elizabeth Smithers of legal firm Clarke Willmott.

Not so long ago it seemed as if inheritance tax (IHT) was becoming a less pressing issue for many people. In 2007, the government introduced the concept of the transferable nil rate band, effectively doubling the amount couples could leave without incurring any IHT liability. There was also mention of the possibility of estates of less than £1 million escaping tax altogether.

In the more austere times that have followed, IHT has again come to the fore with the IHT-free amount that can be left on death (the nil rate band) being frozen at £325,000 since the 2009/10 tax year, and implications that it may be frozen for a further period to offset the cost of implementing the care costs reforms arising from the Dilnot report.

So what can be done to reduce the IHT burden and, if you take action to reduce tax, what safeguards should be put in place to avoid HM Revenue & Customs (HMRC) raising queries after your client’s death?

Click through the gallery to see a step by step look at IHT...

Elizabeth Smithers works at legal firm Clarke Willmott.

Not so long ago it seemed as if inheritance tax (IHT) was becoming a less pressing issue for many people. In 2007, the government introduced the concept of the transferable nil rate band, effectively doubling the amount couples could leave without incurring any IHT liability. There was also mention of the possibility of estates of less than £1 million escaping tax altogether.

In the more austere times that have followed, IHT has again come to the fore with the IHT-free amount that can be left on death (the nil rate band) being frozen at £325,000 since the 2009/10 tax year, and implications that it may be frozen for a further period to offset the cost of implementing the care costs reforms arising from the Dilnot report.

So what can be done to reduce the IHT burden and, if you take action to reduce tax, what safeguards should be put in place to avoid HM Revenue & Customs (HMRC) raising queries after your client’s death?

Click through the gallery to see a step by step look at IHT...

Elizabeth Smithers works at legal firm Clarke Willmott.

Make use of the normal expenditure out of income exemption

Many people are unaware of a valuable exemption that allows gifts to be made from income, and for those gifts to be IHT-free, however large they are and however long the donor survives them.

To qualify, the gifts must be from income made on a regular basis, and the person making the gift must retain sufficient income to maintain their normal standard of living without recourse to capital.

Do not leave your client with insufficient income

If your client has excess income over and above their maintenance needs, this is an ideal exemption to use. It is crucial, however, that in making such gifts they do not leave themselves with insufficient income to pay normal outgoings because HMRC will ask the executors of the estate to show they were not dipping into capital to meet such payments.

Keep records

The chances of the claim for the exemption being successful are therefore much enhanced if, on a yearly basis, records of your client’s net (after tax) income and all outgoings paid (such as mortgage and rent payments) are kept. This should also allow you to calculate accurately how much they can afford to give. In addition, the intention to make gifts on a regular basis should be clearly documented at the outset.

Keep records of lifetime gifts

This is perhaps the best-known way of reducing your client’s IHT liability. Gifts made over seven years before death are free from IHT.

Additionally, it is possible to give up to £3,000 per year without any IHT liability at all, however long before death the gift is made. If a client expresses concerns about passing outright gifts over to their children, then trusts can be used as a protective structure.

Again, HMRC will want to know all about such gifts after death, and the executors’ task will be made much easier if a record of the type and amounts of the gifts and details of the recipients is maintained. Records should be kept of all gifts made in the last 14 years.

Overcome reservation of benefit problems

For a lifetime gift to be effective, the person making the gift (the donor) must retain no benefit from the asset given away. This can affect gifts of land and property in particular because it is not possible to make an IHT-effective gift by, for example, giving a home to children and continuing to live there.

The problem can be overcome by the donor paying an open market rental for continued occupation of the property. However, it is essential to ensure that the rent paid is reviewed over time, so it remains at the correct level, otherwise reservation of benefit will again become an issue.

The important point to bear in mind is that, in those circumstances, the outgoings on the house must be split in accordance with the ownership, so if the house is owned 50/50, the same split should apply to payment of the outgoings. However, this IHT benefit is lost if the child subsequently moves out.

Do not take transferable nil rate band for granted

Each person can leave up to £325,000 to any beneficiary they choose with no liability to IHT. Since 2007, a married couple, or couple in a registered civil partnership, can transfer any unused IHT nil rate band between them.

This means that if one half of a couple dies leaving all their assets to their partner, on the death of the survivor the executors of their estate can claim a percentage of the unused nil rate band of the first to die as well as the survivor’s own nil rate band. The result is that a maximum of two nil rate bands (currently £650,000) can be claimed and the tax bill of a couple could be reduced by up to £130,000.

This does not, however, happen automatically as a claim has to be made to HMRC to transfer any unused allowance supported by documentary evidence. This task is made much easier for the executors of the survivor if supporting evidence from the first death (to include a copy of the will and grant of probate) is retained.

Take account of trusts

On death, IHT is charged on all the assets in an estate after allowing for the nil rate band and any applicable exemptions and reliefs.

Any trust in which your client has an interest can also impact on the IHT payable and details will need to be provided to HMRC.

Some trusts will not be relevant (broadly, discretionary trusts and most lifetime trusts created since 2006), but if, for example, the client has the right to income from a pre-2006 trust, or a trust created by a will, then the value of the capital in the trust may be added to your client’s other assets and IHT charged accordingly.

The executors should be made aware of all trusts, and ideally given a copy of the trust deed and details of who administers it.

You should also consider whether any tax planning could be undertaken during the client’s lifetime. For example, certain trust interests can be given away without any tax implications.

Ensure releases of loans are correctly documented

It is not unusual for a parent to make a loan to an adult child, perhaps to enable them to buy a property. If your client can afford to do so, releasing the loan at some point will ensure that after seven years it is no longer an asset of the estate and taxed at 40% on death.

However, it is crucial to ensure the release of the loan is made in the correct way (ie, by deed), otherwise HMRC will not accept that a valid release has taken place and the loan will be taxed as an asset of the estate.

Factor in the client's business

Probably the last thing on your client’s mind when setting up a business is what happens when they die. However, it is vital to get this aspect of business planning right to secure business relief from IHT, which can reduce the taxable value of their business assets to nil.

On your client’s death, HMRC will want to see the documents for setting up the business, whether it is a partnership agreement or articles of association. The wrong provisions can lead to a refusal of business relief, potentially leading to a large IHT charge.

Shareholder rights matter

For example, your client may have addressed the question of what happens on the death of a shareholder in their company by giving the surviving shareholders the right to buy the deceased shareholder’s shares. However, HMRC may regard this as a contract to sell the shares in place at the date of death and refuse business relief.

This is easily remedied by making sure that instead of a right to acquire the shares cross-options are incorporated, so the surviving shareholders have an option to buy the deceased shareholder’s shares and the deceased shareholder’s estate has an option to sell.

Examine the client's ownership of business premises

Many business owners retain ownership of business premises in their personal names, renting it to the business. However, this has the distinct disadvantage from an IHT point of view because business relief will then only reduce the taxable value of the business asset by a maximum of 50%, if at all.

By comparison, if the business owns the premises, then these will form part of the value of the interest in the business, which will qualify for 100% relief. A simple change such as this can reduce your client’s IHT bill significantly, and will have the added advantage of ensuring that capital gains tax entrepreneurs’ relief, which may be claimable on the sale of your client’s interest in the business, will not be restricted or unavailable because of the payment of a market value rental for the premises.

Don't forget agricultural property relief

Agricultural property relief is another valuable relief, which, like business relief, can reduce the value of agricultural property to nil for IHT purposes.

In assessing a claim for agricultural property relief, among other issues, HMRC will consider the status of the farmer at the date of a farmer’s death, when it will be necessary to show that the property was occupied for agricultural purposes and has been for the entire two-year period leading up to the date of death.

An elderly farmer may therefore need to think very carefully about how best to continue the farming operation, making sure they retain a sufficiently active role, so HMRC is satisfied the property is being used for agricultural purposes at the date of death.

Consider retirement plans

Any plans to retire and pass on agricultural assets to the next generation should also be considered carefully in the light of the need for continued agricultural occupation.

For example, while it may seem attractive for a farmer to retire and gift the farmland to their successors, such a plan will potentially carry a high price tag if the retired farmer continues to live in the farmhouse. In that case, HMRC is likely to argue that the farmhouse is no longer occupied for agricultural purposes and refuse relief.

Take care over the death certificate

Remember that HMRC may take into account all available documentary evidence when assessing the situation after death. Make sure the family are aware of the situation and highlight to them that it would be preferable if your client was not referred to as a ‘retired farmer’ in the occupation section of the death certificate.

...But remember not all farmland use qualifies

Farmers should bear in mind that not all activities carried out on farmland qualify as an agricultural use of the land, and a non-agricultural use will lead to the denial of agricultural property relief.

An example of possible non-agricultural use is fields used for the grazing of horses. Unless the horses are used in the farming business, the agricultural property relief is likely to be denied.

So fields put aside for the grazing of horses used for leisure purposes will not qualify for relief. By comparison, stud farming (the breeding of thoroughbred horses) can qualify as an agricultural use, provided the venture is run as a commercial one, with a view to making profits.

Keep an eye on marketing materials

HMRC will look at all the records of the business in arriving at their determination, including details of advertising and publicity for the stud, so the tax situation should be borne in mind when formulating all marketing materials.

It should be remembered that similar activities that would not qualify for agricultural property relief, such as a livery business, may instead qualify for business relief.

Many farmers today need to diversify away from traditional farming activities for their businesses to be financially viable, but the tax consequences should always be considered.

For example, converted farm buildings used for furnished holiday lets will not qualify for agricultural property relief and are unlikely to qualify for business property relief unless substantial extra services are provided along with the accommodation.

Comment & analysis

Twitter