Avoiding the Burden of Inheritance Taxation

Inheritance Tax has long been assumed to be a rich man’s problem. This is no longer the case. Over the years, Inheritance Tax (IHT) thresholds have, in real terms, stealthily fallen, mainly due to house price inflation. Some calculations suggest that the IHT threshold would be £390,000 if it had risen in line with house price inflation over the past 10 years.

This is, potentially, bad news for the 1.6 million UK homeowners who now fall within the clutches of this tax. In no way do most of these individuals resemble the super rich that were the original targets of capital taxation when it was first introduced early in the 20th Century.

The Chancellor in his last budget before the General Election tried to redress this by increasing the IHT threshold from £263,000 to £275,000 from April this year. Further increases will follow in 2006 and 2007, taking the threshold first to £285,000 and then to £300,000.

Contrary to what one might think, IHT is one of the most avoidable of taxes. One of the best ways of achieving this is to make a Will. The biggest danger of making a Will without the right professional help is that you are almost certain to miss out on simple, but effective, ways of protecting your nearest and dearest from IHT. For instance, most people leave all their assets to their wife or husband, safe in the knowledge there will be no IHT to pay on those assets, as transfers of property and gifts between husband and wife, no matter how large in value, are exempt from IHT (this will extend to lesbian and gay couples under the Civil Partnership Act 2004 which comes into effect in December). But, although that is fine for the spouse, it is not much use to the children. When the second parent dies, anything left in their estate above the nil rate band (the threshold above which IHT bites) is subject to IHT at 40%. If your children are likely to be landed with a tax bill you should consider making use of your nil rate band when the first parent dies, rather than leaving it until the second death. A particular ploy for minimising IHT liabilities is to set up a nil rate band discretionary will trust. This enables you to remove a substantial chunk of assets from your own estate without having to transfer them to someone else, such as your children. When you die, this arrangement allows your beneficiaries to borrow back assets in the trust in the form of an interest-free loan. When they die, the loan is repaid from their estate therefore reducing the size of the estate. This means that when the second parent dies, the children get a second bite of the nil rate cherry.

Assets sheltered in this way are not totally immune from IHT even though they are held outside estates. At every 10th anniversary there may be, depending upon the value within the trust fund, a charge of 6% of the trust value and, at eventual exit, a further 6% charge. However, this compares very favourably with a 40% IHT charge on death.

Because they allow people to avoid hefty amounts of IHT, discretionary trusts are perpetually seen as vulnerable to changes or abolition. So far they have been left alone.

Wills are not the only weapon in the battle to minimise IHT bills and it is best to seek professional advice to discuss what is right for you.

May 2005