Wealthy individuals pay out some £2bn to the Inland Revenue in inheritance tax every year ' but with careful planning, it is possible for them to cut their IHT bill by more than half
Inheritance tax (IHT) is a different proposition to other taxes ' you don't know how much it will be, when it will be and by the time it has to be paid, you'll be gone anyway.
Add to this the typical British reserve about anything to do with death and it is hardly surprising that IHT is one of the most unsheltered taxes. Nearly £2bn a year is paid out to the Inland Revenue for what is arguably a completely optional tax ' so what can be done to avoid it?
There are complications as there is no way of knowing how long we are going to live, how much will be needed to fund our retirement, or whether we should risk gifting to our offspring. The risk is not so much that we will fall out with them but rather that the gifted assets will be eroded through divorce, bankruptcy or insolvency.
But, in the vast majority of cases, wealthy elderly people are just sitting on blue-chip assets from which they are deriving an income and dare not make disposals for fear of paying 40% capital gains tax. Most choose not to take into account the fact that, on their death, 40% will be paid out in IHT.
The key is to persuade these people of the benefits of disposing of mainstream assets and thereby giving rise to CGT. By then deferring the CGT through investment in unquoted firms that qualify for enterprise investment schemes (EIS), they can avoid IHT if they live for a further two years. At this, point you lose most of your audience because of the refusal to consider unquoted companies as a viable option.
People reacting in this way are probably failing to recognise that unquoted now includes a wide selection of options. This includes Aim- or Ofex-listed and genuinely unquoted companies, but also bespoke or special purpose organisations.
These companies do not have to be high-risk, high tech businesses ' there is also a reasonable choice of asset-backed options, such as pubs, garden centres or children's nurseries. The last two are particularly interesting as these are solid UK businesses that are experiencing strong growth, with demand outstripping supply.
Aim is slowly growing in popularity. The attractions here are the comparative liquidity of an Aim portfolio (on death it can be sold in the market if required), the availability of accelerated taper relief and the exemption from IHT on death.
Accelerated taper relief is about to be enhanced and it is probable that any disposals of Aim holdings after 5 April this year will be subject to only 10% CGT, provided they have been held for a minimum of two years (down from four).
Aim had a sensational year in 1999, putting on something in the region of 145% in value before crashing to earth in 2000 and 2001. It is arguable that now is a good time to be going back into Aim, as we are likely to be close to the bottom of the cycle.
The great family debates about whether to gift to offspring or what IHT avoidance measures to take are often resolved with the onset on senility, with power of attorney and become free to make the tax-efficient arrangements.
We see a steady stream of 60-year-old clients seeking IHT-exempt investments of behalf of an elderly parent. EIS portfolios and bespoke nursery firms tend to be the most popular options, but it all takes a lot of time and it would often have been so much easier if the process had been started earlier.
The benefits of avoiding what we call the double hit of CGT and IHT can be huge. Take the example of Stan, who sells his business to retire, pays 40% CGT on the profit and then suddenly dies, at which point another 40% is paid out in IHT on the shrunken post-tax amount.
So, a £3m gain from the sale of the business can become £1m in the space of just a few years. His friend Ray also makes a profit of £3m on the sale of a business but skillfully re-invests into good quality unquoted investments. Ray will probably preserve his £3m and possibly add to it significantly (tax-free) over the course of the next five to 10 years. On death, Ray's widow could be worth £5m, compared with Stan's widow, who is worth about £1m ' a huge contrast in fortunes in a relatively short time span.
The wealthy elderly are a growing breed and estates of £3m, including the family home, are increasingly commonplace. In such circumstances, the IHT bill can easily be more than £1m.
The first step to mitigating this would almost certainly be the nil rate band strategy ' each elderly spouse gifts £242,000 into a family trust, from which benefit can be derived during their lifetime but is tax free on their death.
Next, we need to consider the family home, which might well be a third of the £3m. There is a way of gifting the family home and remaining in it without incurring IHT, which involves a complicated matrix of IOUs but so far seems secure and non-vulnerable to Inland Revenue attack.
The remaining £2m will probably be blue-chip shares and bonds, which attract a straight 40% tax above the IHT £242,000 threshold.
Clients have three choices: hang on to them and their estate will pay 40% on their death; sell them now and pay 40% CGT; or sell them, re-invest into the unquoted sector, defer the CGT and avoid IHT on death.
This strategy only works if you can find the profitable unquoted investments and the other drawback is that unquoted investments are rarely good for producing income. There is a solution but it requires a lot of advance planning and hard work: provided they start early enough, clients should sell about one-fifth of the mainstream assets and start the process of progressively converting from mainstream to unquoted.
Doing it 20% at a time over a period of years will give clients the opportunity of realising tax-free profits from the first phase while they are still halfway through the conversion process. This will yield the vital income required ' a lumpy form of income and by no means guaranteed, but what is guaranteed today?
Martin Sherwood is head of tax-efficient solutions at Teather & Greenwood
1. Small gifts exemption: You can give small gifts worth up to £250 to any number of people in any tax year and they will not be subject to inheritance tax. But you cannot give any one person more than this and then claim exemption on the first £250; as it will no longer qualify as a small gift.
2. Annual exemption: You can give away £3,000 a year free from inheritance tax. And if you don't use the full £3,000 in one tax year, you can carry it forward to the next tax year. But you cannot use this £3,000 exemption to top up the small gifts exemption: if you give someone more than £250 in a year, then it comes off this £3,000 annual exemption.
3. Gifts made out of normal income: If you make regular gifts out of your after-tax income, not your capital, then these are not subject to inheritance tax. These could include birthday or Christmas presents, but you must not have dipped into your capital to pay for them or to subsidise your normal standard of living. As far as the taxman is concerned, your standard of living must not be altered by making such gifts, or they will not be exempt from inheritance tax.
4. Wedding gifts exemption: To celebrate a marriage, each parent of the bride or groom can give the happy couple £5,000 free from inheritance tax; for grandparents or other relatives, the figure is £2,500 and for anyone else, £1,000. You must make the gift before the wedding, and should the wedding be called off, then the gift goes straight back into the inheritance tax net.
Source: The Inheritance Tax Planning Group
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