IHT - the forgotten tax

Inheritance tax revenue rose by 14% in 2010/11 but is still 29% below its peak in 2007/08.

Many factors can be used to explain the drop, ranging from falling house prices, investment performance and individual tax saving measures such as the introduction of transferable nil-rate bands.

With headlines such as these, IHT could fall down your clients’ financial planning ’to do‘ lists. However, IHT collection still generates £2.7 billion pounds in revenue. Articles often quote IHT as a ‘tax of choice’. It’s a good time to remind ourselves of some of the IHT mitigation solutions available.

One of the key IHT planning exercises is to make use of all IHT exemptions where appropriate. There are a number available: Annual exemption, normal expenditure, small gifts, gifts to exempt parties, e.g. charities to name but a few. Just as a brief reminder some of them are as follows:

Annual exemption

This is an amount that can be gifted free of IHT. Currently the amount is £3,000 per year. Where the exemption has not been used in the previous tax year the amount can be carried forward but only for the current tax year – giving a maximum of £6,000. This exemption is available per individual and there are no restrictions on the recipient of the gift. For a married couple or civil partnership this therefore could mean a combined gift of £12,000.

Normal expenditure out of income

A transfer made out of normal expenditure of income will be exempt, providing a number of criteria are met. Firstly, the transfer has to be made as part of the normal expenditure of the person making the transfer (the transferor). Secondly, it has to be made out of natural ‘income’ for example from dividend payments, or interest from investments or salary. Thirdly, after allowing for all transfers which are part of normal expenditure, the transferor has to be left with sufficient income to maintain their usual standard of living. Finally the transfer has to be habitual or regular.

Though, strictly speaking not an exemption – the nil-rate band should also form part of any planning strategy. There are a number of IHT mitigation schemes available which have stood the test of time – two examples of these follow.

The loan trust is a vehicle which allows your client access to a capital sum (the loan) whilst any growth on that sum is immediately outside the settlor’s estate. There are no age or health restrictions associated with the IHT savings, although any IHT benefits will be impacted by the amount of time the settlor lives after the IHT planning exercise.

The loan trust is an arrangement where a loan is made by an individual (the settlor/the lender) to trustees of a trust (either discretionary or bare) which the trustees then use to invest into an investment vehicle, usually a single premium investment bond. The loan is interest free and repayable on demand. Once the loan is made, any subsequent growth on it will immediately be outside the settlor’s estate.

The effect of the loan trust is best explained in the form of a case study;

Jake makes an interest free loan of £1,000,000 to his chosen trustees, Anthony and Duncan. This money is held on discretionary trust. The trustees invest the money into an investment bond. If we assume no loan repayments are made for the first five years and the bond grows at a rate of 5%, in the first year the growth would be £50,000 and by year five the growth would be £276,282. This would give an immediate IHT saving of £110,513 (i.e. 40% of £276,282). Jake requests repayment of the loan over the next 15 years. He spends the repayments on holidays and home improvements. Unfortunately, Jake dies shortly after this time. The investment bond has grown to £557,000, which provides an IHT saving of £222,800. This is held in trust for Jake’s chosen beneficiaries.

The discounted gift trust can be described in brief as a scheme which lets the settlor make a gift whilst retaining a right to withdrawals.

Assuming that a client is of standard health for their age and below the age of 90, there should be an immediate IHT saving. Consider Julie. She is 78 and in excellent health for her age. Her financial adviser has identified that she has an IHT problem and has recommended a discounted gift trust as one way of mitigating IHT. Julie makes a gift into a DGT of £500,000 and retains a 5% right to withdrawals. Based on a number of factors, such as age, health and interest rate assumptions, Julie is deemed to have made a discounted gift of £272,249. This means Julie has made an immediate IHT saving of £91,100 (ie 40% of £500,000 minus £272,249). The growth on the trust fund is also immediately outside of Julie’s estate.

One of the key differences between the DGT and the loan trust is that the settlor is unable to demand the full capital at anytime and the entitlement to withdrawals is fixed.

IHT is a curious tax as its impact for most will only become clear after a client’s death. However, with careful planning and an adviser who is offering the full spectrum of financial planning, there are ways to lessen its impact.