Inheritance Tax

What is Inheritance Tax?

Inheritance Tax (IHT) is a tax due on the total estate of a person. That is, the total value of any property, investments, money and personal property like cars or jewellery. IHT is currently 40% of everything over £325,000.

How to Calculate IHT?

IHT can be determined by assessing the value of an estate. This means combining the value of all the assets, and subtracting the value of all the liabilities such as debts or other taxes due like Income tax. The gifts made by the deceased within the last 7 years must also be included. Certain types of property may be exempt or partially exempt from IHT including agricultural land, woodland or wedding rings.

Of the value of the estate, the first £325,000 are tax free. Everything after that is taxed at 40%. As such, an estate worth £200,000 would pay no IHT, but an estate worth £600,000 would pay £110,000 in IHT.

When is IHT due?

The executor or administrator of the estate must submit an Inheritance Tax account to HMRC before applying for a Grant of Probate, and arrange to pay the IHT. If the amount is small, it will be possible to pay this up front. However, if there is a large amount due then this is impractical as assets may need to be sold before a payment can be made. As such, HMRC may come to an agreement regarding delayed payments. Finally, there are private loans available to bridge the gap between IHT and selling the property.

If no attempt to pay is made within 6 months of the deceased death, HMRC will charge interest on the tax due.

Reducing IHT Liability

There are several simple ways to reduce or eliminate IHT liability. If the entire estate is passed to the deceased spouse or civil partner then there is no IHT due. Furthermore when the spouse passes away the boundary for IHTfor their estate will be £650,000, combining both spouses tax free allowance. Likewise, if the entire estate is passed to an exempt beneficiary such as a registered charity then there is no IHT due.

The final common method for reducing IHT liability is the Residence Allowance, which adds a further £100,000 to the tax exempt allowance if passing the family home onto a child or grandchild.

As such, an estate worth £600,000 passed entirely to a spouse or charitable cause would pay no IHT, and a estate worth £600,000 that passes the family home on entirely to the children or grandchildren would owe £70,000.

Gifts

The use of gifts and of trusts can also be used to reduce the potential IHT bill.

Gifts of any size made at least 7 years before the death of the giver are not subject to IHT, but any made within 7 years will be included in the valuation of the estate, and may be taxed. Every person has an annual allowance of £3,000 of gifts that will never be taxed, no matter when they were made.

Certain types of gift are also exempt.

  • Gifts less then £250. These do not count towards the £3,000 limit, though can not be given to anyone who has received a non-exempt gift.
  • Wedding gifts below £5,000 for children, £2,500 for grandchildren and £1,000 for anyone else. The gift must be made before the wedding, and the wedding must go ahead.
  • Gift from surplus income, that is if a person has enough income to maintain their style of life they can make payments towards supporting others by paying into a child saving account or supporting an ex-spouse.
  • Gifts made to help with living costs for any dependants, children who are minors or in full time education or ex-spouses.  
  • Charitable Gifts
  • Gifts to political parties under certain circumstances.

All types of gift exemptions are subject to complex rules. A person should keep excellent records of gifts and should seek advice from a solicitor or tax accountant before embarking on programme of gifts to reduce inheritance tax liability. 

Trusts

Trusts can also be used to limit liability. A trust is a legal arrangement where a person gives some of their assets to a third party to hold on trust for a beneficiary. For example, a person might leave £5,000 in trust with their friend for their grandchild. Here the grandchild is the beneficiary and the friend if the trustee. See Trusts for more information on trustees and beneficiaries.

In relation to IHT a trust is useful because once the property or asset has been passed to the trust, it is no longer owned by that person and so can not form part of the estate. However, trusts must follow very specific rules to achieve the most benefit, and most will still attract some form of taxation, be it Inheritance tax, Income tax or Capital Gains tax.

Trust types:

  • Interest in Possession – the beneficiary has no rights to access the capital of the trust (money or property) but is entitled to the income generated by them (either in interest or rent). The Beneficiary may have to pay Income tax.
  • Discretionary trust – the trustees are given full control over the capital of the trust, the income, investment decisions and the eventual distribution. This is commonly used to leave an inheritance for grandchildren by making their parents the trustees.
  • Bare trust – this transfers the full value of the trust to the beneficiary as soon as they turn 18.
  • Mixed trust – This combines trust types allowing for a tailored trust. A house might be held as Interest in Possession trust, a cash sum as a Bare trust and a stock portfolio as a Discretionary trust.
  • Trust for a vulnerable person – if the sole beneficiary of a trust is a vulnerable person the income and capital of the trust may be subject to tax breaks or exemptions.
  • Non-resident trust – if the sole beneficiary of the trust is not a resident of the United Kingdom, they may also benefit from tax reductions or exemptions.

Before setting up a trust, careful consideration must be made of the aim of the trust and advice should be sought on the best way to create and manage the trust. They are exceptionally complex area of law and taxation and incorrect use could cost far more then the tax would have been.