International Estate Planning - Taster

This is the 3-Minute taster for my full-length International Estate Planning seminar.

Inheritance Tax Strategy 6 - Use Your "Business Property Relief"

Business Property Relief is usually abbreviated to “BPR”.

1.           The basic principles are:

              a.           Sole traders get 100% BPR on their business and its assets. (100% relief means no tax to pay at all, whether on a lifetime gift or at death.)

              b.           Partners get 100% BPR on their share of the business. (Even members of Limited Liability Partnerships get this relief.)

              c.           All shareholdings in unquoted companies get 100% BPR. Shares which are traded on the Alternative Investment Market are unquoted for this purpose, so you’re still OK to claim BPR on them.

              d.           Partners get 50% BPR on assets owned by them personally but used by the partnership. (50% BPR, of course, means you pay tax on half of the value of the assets.)

              e.           Controlling shareholders (only) get 50% BPR on assets owned by them personally but used by the company.

              f.            Controlling shareholders of PLCs get 50% BPR on their shares (although if you control a PLC you are one of a very rare breed).

              g.           Generally there’s no actual need to work for the business, or be actively involved in management. The fact that you are a financial backer (such as a sleeping partner or an inactive shareholder) can be enough to get you BPR.

              h.           Everybody is denied BPR on the investment element of the business, so part of the claim will be rejected if the business holds assets such as lots of cash, stockmarket investments, or properties which are let.

              i.            You generally need to have had the business interest in question for over two years to get any BPR.

             

2.           These rules are very generous compared to taxes we’ve had in the past. There’s a good chance that this won’t last. Tax plan now.

3.           You need to be quite careful to ensure that what your business does really is business, as distinct from letting or investment. A business which is chiefly based on rental income, for example, isn’t a “business” in the “business property relief” sense of the word. 

              Just to emphasise the effect of my points 3 and 1(h):

              i.            if the business is mainly investment or letting then you don’t get any BPR at all, on any of it (even the non-investment/letting part); but

              ii.           even if you do get BPR on the business as a whole, it’s refused on the part of the business’s value that is attributable to investment/lettings.

4.           Gifts of your business assets are likely to have capital gains tax consequences. Make sure that any tax plan takes into account the impact of both taxes.

5.           In the case of a lifetime gift, there is a particular trap to watch out for, in the “clawback” rules. These kick-in if BPR is claimed, but the assets in question stop being eligible for BPR by the time the giver dies. These force you to go back and recalculate inheritance tax as if BPR had never been available in the first place, which of course could be a disaster.

6.           The single most important thing in estate tax planning for people whose assets potentially qualify for BPR, is to ensure the BPR is “used” (not “wasted”). It can be used in two ways: firstly by passing the business directly on to a lower generation (e.g. children/grandchildren) or secondly by putting the business onto a First Death Discretionary Trust. BPR gets “wasted” by leaving the business outright to the surviving spouse. The reason this is a waste is that you have used two reliefs (business property relief and the spouse exemption) against the same assets when either one would have done, in consequence of which the surviving spouse has got richer. Then, the surviving spouse can live on for many years, eventually retiring and selling-out of the business, then dying with a huge wodge of cash to be taxed at 40%.

              So if you only take one message from this posting, then it’s this one, which I will set out in big bold lettering for you:

              DON’T WASTE YOUR “BPR” WHEN YOU DIE!!!

7.           This final point isn’t so much a strategy in its own right - more an important problem to be aware of.

              When you sell a business, you are turning an asset (the business) which potentially qualifies for 100% BPR - making it tax free - into another asset (cash) which is going to be taxed in full at your death. There is action you can take to deal with this problem, so you should be sure to take advice on the point before you start negotiating any sale. 

Rysaffe Planning

NOTE: Since I posted the below (September 2012) the government have consulted on whether Rysaffe arrangements should be allowed to continue. At the time of this note (October 2013) no decision has yet been made. If you have these arrangements they could need review. Entering into them also needs to be considered more carefully. 


One of my more technical postings, dealing with a less-common piece of planning for people with larger inheritance tax problems

Discretionary trusts are a good thing once assets are inside them, for the reason that their assets are not owned by a human being and the trust cannot die, thereby never suffering the 40% “tax whammy” that inheritance tax represents. However such trusts are also a bad thing inheritance-tax-wise for several reasons:

a. There’s no exemption when you leave money to a discretionary trust (as there is, for example, when you leave money to a spouse or charity).

b. Giving money to a discretionary trust (indeed to most types of trust) in your lifetime is not a “potentially exempt transfer” like other gifts are: instead you have to pay half of the death-rate IHT right there-and-then upfront (that’s 20% of the amount you pay in, less the £325,000 “nil-band”) and you do not get this money back even if you survive for seven years. However if you do die within seven years you have to recalculate the tax and may have to stump-up some or all of the remaining 20% to make up the 40% death rate.

c. Discretionary trusts suffer “ten year charges” – inheritance tax on the value of the trust over the nil-band at rates up to 6% every ten years.

d. Discretionary trusts suffer “exit charges” – inheritance tax on the value of funds leaving the trust over the nil-band in between ten-year anniversaries, at rates up to 6%.

So, having found an acceptable way to get money into a discretionary trust, is there anything that can be done about items (c) and (d)? Yes, there is, if you plan in advance and if you consider the tax problem sufficiently serious to justify the costs. What you do is this: you establish, in your lifetime, a number of small discretionary trusts. By “small” I mean that the amount of money in them is small – usually £10 – but in all other respects they are full-blown trusts – you sign-up to trust deeds and appoint trustees who take office. The number of trusts you need is found by dividing the amount you want to settle onto discretionary trusts by the current nil band, rounding up. If you have £2million, for example, you need seven trusts. You create each of these trusts on a different day.

When you die, you make a gift of somewhere less than a nil-band to each trust, in your will. The advantage is that because each trust was established on a different day, it has its own nil-band. And, as I mentioned above, the ten year charges and exit charges are charged on assets over the nil-band. And that is likely to be nothing, or very little, if the trusts each start with less than one nil-band.

Is it Better to be Married?

I would never tell a client whether it is better to be married!

I do think, however, that it is legitimate to ask whether it is better, from an inheritance tax viewpoint, for a couple to be married. The answer seems to be “yes”, but I cannot find a very simple way of explaining it. The best I can do is to set it out arithmetically. Let’s imagine a couple who each own £2,000,000, and let’s start with the worst case scenario, which is that they are unmarried and leave everything to each other:

What has happened here is that the total inheritance tax they have paid, £1,872,000 is extremely bad news, and is actually MORE THAN 40% of their total assets, even though 40% is the tax rate. The reason is that some of this money has been taxed twice, once when he died and again when she died.

(Don’t worry about the detail of these calculations, by the way, just keep an eye on the “total tax” number!)

Being married does protect against some of that tax. For example, a married couple could do this:

The total tax has reduced to £1,340,000: which is still a lot of money, but does at least seem ‘fairer’ than the first example in the sense that the tax comes out at 40% of the taxable portions of the estates. The tax saving is over half a million pounds and, significantly, none of it was paid on the first death – it was all postponed until after both had died.

Can an unmarried couple achieve that same bottom-line figure? Yes, they can: for example by incorporating discretionary trusts in their wills:

This third example has the same bottom-line as the married couple achieved. Notice, though, that there is one significant difference. This time some of the tax, £670,000, was paid on the first death. An unmarried couple cannot shield that until the second death, as a married couple can.

Inheritance Tax Strategy 5 - Make Regular Gifts

A good way of saving inheritance tax is to give regular sums to the family, each year, using your inheritance tax exemptions. There are four exemptions within which you can give money away, and these are:

1.           The Annual Exemption.  You are allowed to give £3,000 per year away, free of tax.  If you did not use this exemption in the last year you are allowed to carry it forward, so in the first year of a scheme of giving you can give away £6,000.

2.           The Small Gifts Exemption. This allows you to give £250 each year to any number of individuals.  This is particularly suitable if you have lots of grandchildren, nieces, nephews etc. because you can give £250 Christmas presents to every single one of them and the money will be out of your inheritance tax estate straightaway.

              You need to be quite careful with this exemption, because the rules are quite strict. Taking just two examples:

              a.           If you give someone £3250, that is not a £3000 annual exemption plus a £250 small gift, as you might think. The balance over £3000 is potentially taxable.

              b.           If (having used up your annual exemption elsewhere) you give someone £300 then that is not a £50 gift plus a £250 small gift, as you might think. It is a £300 gift and will be taxed as such if you die within seven years.

             

              Basically, the small gifts exemption just doesn’t mix with the other exemptions.

3.           The Regular Gifts out of Income Exemption.  This is a very useful exemption because there is ABSOLUTELY NO LIMIT on the amount you can give away.  However, what you are giving away must be SURPLUS INCOME.  That is:

a.         it must be paid out of your income, not from your capital; and

b.         it must be surplus, meaning you must be left with enough income – after making the gift – to maintain your own usual standard of living.

              It is nevertheless a hugely useful exemption for those whose income exceeds their outgoings. It is more difficult to establish than the others, however, and it’s important to speak to your advisers to make sure you get it right.

4.           The Wedding Gifts Exemption. This is a fairly minor exemption. The following people can make IHT-free gifts to the happy couple, in the following amounts:

Parents: £5,000 

Other ancestors (e.g. grandparents): £2,500 

Anyone else: £1,000 

A party to the marriage: £2,500

Crucially, many people who set up schemes of giving assume, wrongly, that they should think of £3,000 per year as the upper limit of the gifts they make. This is wrong, and it can be demonstrated by an example. Let us suppose that a Mr. Smith has quite a large tax estate, which includes £100,000 in a deposit account. He is trying to decide whether to make regular gifts from that money. Let us also imagine that in the event he dies 10 years after making this decision.

In scenario 1 he decides not to make any gifts at all.  He suffers inheritance tax on £100,000 at 40%, which is £40,000.

In scenario 2 he decides to give away £3,000 each year.  This saves tax on £3,000 x 10 = £30,000, so he pays tax on £70,000, which at 40% is £28,000.

In scenario 3 he decides to make gifts of £10,000 each year.  The gifts from the first three years do not form part of his tax estate at all (because he survived 7 years after making them), and he is allowed to deduct £3,000 from each of the others.  He is therefore taxed on 7 x £7,000 = £49,000, on which tax at 40% is £19,600.

What you can see from the above three scenarios is that the larger the gifts you make, and the longer you live from the start of your scheme of giving, the bigger the tax saving will be.

Inheritance Tax Strategy 4 - Make Large Gifts

Technically, this strategy applies to most gifts in excess of £250, but obviously a small gift of that kind does not create much of a tax saving in your estate.  Much larger gifts, however, can have a considerable effect. 

Any large gift you make is known in technical language as ‘potentially exempt’ - meaning that it will be taxed if you die within seven years, but it has the potential to become exempt from tax if you survive the seven years.  (You’ll sometimes hear lawyers talk about a “PET”, which is an abbreviation of “Potentially Exempt Transfer”, and is usually just another way of talking about a large gift.)

For the very wealthy, this is the most important tax saving strategy.  There is no limit to the size of gift you can make (for example to your own children) and if you survive the seven years it will be tax free.

If the gift does eventually become taxable, because you die within the seven years, then it will be taxed on a sliding scale. This is called “taper relief”. If you survive three years from making the gift the rate of tax falls by a fifth, from 40% to 32%.  If you survive four years it is 24%, five years is 16%, and six years is 8%.  It is very easy to become misled by this sliding scale however.  If the original gift was within your nil band then the sliding scale will never apply to it.  It is only larger gifts which get this advantage. (If you’re interested, this is because it’s not the value of the gift that tapers, it’s the rate of tax that tapers: and the nil rate band gets its name because it’s taxed at “nil-rate” i.e. 0%. And however much you taper 0%, it is still 0%. People imagine, for example, that if they make a £100,000 gift and survive three years, they’ll be taxed as if they had made an £80,000 gift and therefore save tax on £20,000 from their death estate. But they are wrong. They have to survive 7 years for their saving: and of course if they do survive that long the gift is out of the tax estate completely.)

There is a school of thought which says that those with considerable wealth should give away to younger generations of the family as much as they can afford to give away, and as young as they are able to do it. However, this must be a matter for your personal choice, and it would obviously be wrong to make gifts which were not prudent or which left you exposed to financial difficulties later in your life.

There is no financial limit to Potentially Exempt gifts. You can gift fifty billion pounds tax free, if you have that sort of money lying around.

A WORD OF WARNING: It quite often happens that people with inheritance tax problems don’t have any assets to “tax plan” with, except those which they need for themselves. A good example of this is the widow who only has the house and a portfolio of investments, and she lives off the income which those investments produce. It is tempting to transfer the house and investments into the names of the children. The problem with this arrangement is the “gift with reservation” rule. This rule says that if you give something away, but continue to receive some benefit from it, then it stays in your tax estate. You’ve given away your financial security and have got no benefit whatsoever from it. You will be living for the rest of your life off the charity of your children, and in the event they may prove not to be as charitable as you hope. (If you need more advice about this problem, you might like to read a play called “King Lear”, which is available from most good bookshops.) That’s not to mention the horrendous consequences which would follow if one of your children died before you, or became divorced, or lost their mental capacity, or went bankrupt.

Inheritance Tax Strategy 3 - Give It To Charity

All money given to charity is completely free of tax.  If you give money to charity during your lifetime then it is out of your inheritance tax estate straightaway.

Every gift made to charity by your Will is deducted from your estate before the inheritance tax is calculated.

People who have no dependants and are able to leave their entire estates to charity naturally pay no IHT whatsoever.

Gifts to charity are particularly useful for those who would like to get rid of a very small IHT problem, or (at the other end of the scale) for those whose beneficiaries have lots of independent wealth of their own, and whose money might therefore be put to better use in the charitable sector.