7 April 2013

Common Misconceptions About Inheritance Tax


The following ideas about IHT somehow seem to have entered the public imagination.

They are all wrong:


If I put all my assets offshore then they won’t be charged to Inheritance Tax.

WRONG!

This is wrong. UK domiciliaries pay IHT on all their assets worldwide.


If I put all my assets in the name of somebody else, they won’t be charged to IHT.

WRONG!

This is wrong. I know people who’ve taken the hugely risky step of putting their homes and investments into their children’s names, in the utterly mistaken belief that it will save tax. Gifts obviously do have their place in tax planning, though, and are discussed in some of my other posts.


I can put all my assets into trusts, and carry on treating them as my own. They’ll then be tax free.

WRONG!

Not so. Generally, the type of trust which is tax effective is the type which prevents you from benefiting from it. Your advisers can perform minor miracles on your behalf with trusts, though, and some of the strategies are mentioned in other posts.


I can form a charity and run my life through it. Then everything I do will be tax free.

WRONG!

Not so, either. Money put into a charity can never be withdrawn again for private purposes. By all means give money to existing charities. By all means create a charity if you have an enterprise that deserves charitable status. But don’t think of a charity as the core of a tax-plan, because that will not work.


If I hold my assets jointly, they won’t be part of my estate, and therefore won’t be taxable.

WRONG!

This is wrong. Your “tax estate” is bigger than your “estate”, and includes your share of jointly held assets.

I expect this misconception arises from two things:

a.            firstly because a little knowledge of the law is a dangerous thing, and many people have cottoned on to the (correct) idea that joint assets are not in your “estate”; and

b.           because, in fact, assets held jointly by a husband and wife do pass to the survivor inheritance tax free – and people have seen this happen, perhaps with their parents. However, that had nothing at all to do with the joint ownership: transfers between husbands and wives always are inheritance tax free, due to the “spouse exemption”.


The “£3,000-a-year gift”, which is mentioned so often in the financial pages of the newspapers, is one of the best things you can do to save tax.

WRONG!

Not really. It is quite a painless way of saving tax, but you would have to do it for years and years before you made any serious inroads into your tax problem. The rules are explained in other blog posts. But look at other, better, strategies first. And, as explained here, limiting yourself to £3,000 is not necessarily wise.


Debts are Deductible.

WRONG! ish

I always have trouble with this one. After all, debts ARE deductible from your tax estate, so my clients are always a bit nonplussed when I insist on ignoring their debts when I calculate their inheritance-tax exposure. But there is method in my madness. The trouble with debts is that so often they come with built-in safeguards for paying them off. Endowment mortgages, for example, have life-cover built into them. Repayment mortgages are usually attached to mortgage protection policies. Credit card debts, store cards and financing deals are often covered by payment protection.

Also, these protections usually kick-in on the first death. So a young couple with 10% equity in a £1million home, and not much else, might think of their wealth as £100,000 and therefore outside the tax net, whereas actually the second-death estate would be £1,000,000, with a six-figure tax exposure.

Besides, guess what, if we find that you do have unprotected debts, then we’ve already discovered an inheritance tax saving!

Always start calculating from your gross estate.

IHT on Gifts to Minors in Wills


It makes me weep that I need to discuss this. I genuinely do not believe that the government intended to make this bit as complicated as they did. The old (pre-2006) rules for gifts to minors, called the “A&M Trust” rules, were simple, secure and tax-favourable. So, everybody followed them, leaving gifts in wills “to those of my grandchildren who survive me and attain 21” or suchlike. Very straightforward. Nobody thought of creating “bare trusts” (whatever they are) or leaving their children “intermediate income” (whatever that is), because although those options existed in theory, frankly why would you want to do them, and who needs to think about those things, anyway? Well, now you do.

I think the treasury felt that some very rich people with clever lawyers were taking advantage of the A&M Trust rules, so, using a sledgehammer to crack a nut, they simply abolished them. Then, they realised that they needed at least two new statutory regimes to partially replace them. So now, you need to consider a string of options, and to trade-off simplicity -v- security -v- tax-favourableness. Instead of the one option you had before (where the only choice you really had to make was whether the beneficiaries inherited at 18 or 21 or 25, and where even that decision didn’t affect the tax position) you now have to choose between:

a.            Relevant Property Trust. (Example: “to those of my grandchildren who survive me and attain 21”.) Simple, secure, tax-unfavourable. This is the simple option I mentioned above, the kind that would previously have fallen squarely within the A&M Trust rules. This is still unquestionably the best option for those whose estates aren’t in the tax net anyway – indeed, if you aren’t in the IHT net this is the only option I would seriously discuss with you, if you consulted me about a will. The tax disadvantage, however, is that they are taxed as discretionary trusts, suffering ten-year charges and exit-charges. The maximum rate of any charge is 6%, so what I often find is that people whose estates are taxable nevertheless work their way through the following options with me, but then decide to come back to this one: taking the view that the tax charges may be a reasonable price to pay for the simplicity and security of it.

b.           Bereaved Minor’s Trust. (Example: “to those of my children who survive me and attain 18”.) Simple, insecure, tax-favourable. This is a statutory regime, available only in the wills of the parents of the child concerned, and only where the minor gets their money outright, with no strings attached, at 18. And, really, that’s what I mean by “insecure” in these examples – the minors in question taking absolute control of their inheritance the moment they reach 18, whether or not they are mature enough to handle the amount of money involved. The tax advantage is that there are no ten-year charges or exit-charges.

c.            18 to 25 Trust. (Example: “to those of my children who survive me and attain 21”.) Simple, secure, tax-middling. This is another statutory regime, available only in the wills of the parents of the child concerned, and only where the minor gets their money outright, with no strings attached, at an age between 18 and 25. Gifts of this kind become relevant property trusts upon the minor in question reaching 18. Therefore there cannot be a ten-year charge (because there are less than ten years between someone reaching 18 and the same person reaching 25) and the maximum possible exit charge is 4.2% (because exit charges are calculated by reference to the number of years elapsed before the next ten-year charge would happen: in this case there are seven years between ages 18 and 25, and 7/10ths of the maximum 6% is 4.2%).

d.           Bare Trust. (Example: “to those of my children who survive me absolutely”.) Simple (in theory), insecure, tax-favourable [unless the minor dies]. In this case, the gift to the minor is “absolute”, so he or she owns the money outright, even if he or she is only an infant. This may seem to be the ultimate in insecurity, although in practice trustees do actually have to look after the money and the child cannot demand it from them until attaining majority, at 18. The only reason to consider this is the tax consequence: the money actually belongs to the child, so the trust isn’t truly a trust at all, and isn’t taxed as one. Therefore there can be no ten-year charges and no exit charges.

e.            IPDI. (Example: “to pay the income to those of my children who survive me, from the date of my death, and to pay the capital to each of them when he or she attains 21”.) Complicated, secure as regards capital, tax-favourable [unless the minor dies]. The idea of an IPDI is that if you grant someone a right to income, by a trust in a will, from the date of death, then that trust is taxed in tandem with the beneficiary’s estate (and not as a relevant property trust). The tax upside is that there are no ten-year and exit charges. But the assets are taxed in tandem with the minor’s estate, so if the fund is big enough it suffers 40% tax on the minor’s death.

But just to clarify: although I have described some of these options as “tax-favourable” and “tax-unfavourable” none of them avoids the IHT on the death in question (and the old rules didn’t do that either). Leave money to a child or a grandchild (indeed, actually, to anyone except a spouse, civil partner or charity) and you pay IHT on it. The only question we are discussing in this section is whether there might be yet further IHT on the fund before the minors receive their share.