Gerry Brown discusses the benefits of IHT planning
Gerry Robinson's Friday night TV series Can't Take It With You on BBC Two made fascinating viewing. While not billed as reality TV, it dissected a number of real-life situations where difficult decisions had to be made about the passing of wealth from one generation to the next, usually - but not inevitably - on death.
Despite ongoing publicity over the benefits of a will, only 30% of us actually have one. Perhaps this is a reflection of a general reluctance to discuss money and death, as well as a desire to defer or avoid complex and emotion-laced decision making.
The inheritance tax (IHT) consequences of the various strategies adopted by the families "under the microscope" was not analysed in depth. Perhaps this is as it should be. The key objectives of the eldest generation were firstly to pass wealth on in a way which protected established businesses, and secondly (and subserviently) in a way that achieved a degree of fairness between the various beneficiaries. To impose an additional tax minimisation objective might have been a step too far.
That is not to say IHT planning is unimportant - far from it. However, it is not an end in itself and should complement other financial planning objectives.
In January 2010, the leading law firm Withers - which provided the technical input into Can't Take It With You - conducted a survey which suggested that IHT planning was of significant importance to 49% of clients (or clients of professional connections).
This survey was undertaken before the general election, at a time when it was widely expected that a Conservative government would raise the nil-rate band to £1m. Great expectations maybe, but the reality is in these hard times, it has been frozen at £325,000 until 2014-15.
It seems reasonable to assume that should a similar survey be carried out now, the percentage of clients for whom IHT planning was a key topic would be significantly higher.
The main IHT planning strategies have changed little over the years. Given that it is primarily a tax on the value of an individual's estate on death, the main strategy must be to reduce the value of that estate.
In addition, given that a raft of exemptions and reliefs are available, estate reduction techniques should use them as far as possible.
In some situations, estate reduction techniques may not be appropriate and it may be necessary to plan to fund the tax bill from savings - use of a whole of life policy in trust is the usual way to fulfil this strategy.
The use of pension contributions in IHT planning is often underestimated. Pension funds are generally "excluded property", which basically means that they are ignored for IHT purposes - they do not form part of the scheme member's estate. Death benefits are distributed at the scheme administrator's discretion - this distribution is not an IHT transfer of value.
Should the member survive to take pension benefits, the annuity or income drawdown payments will be consumed in day-to-day expenditure and should not significantly affect the estate.
Should the annuity or income drawdown exceed amounts needed for day-to-day expenditure, the excess can be used in strategies to avail of "normal expenditure from income exemption".
Additional planning is required where the client has Section 226 or Section 32 pensions. Death benefits under these arrangements are not paid at the administrators' discretion and would thus fall into the IHT net, unless held under a suitable trust.
Solutions to this problem could involve placing the death benefit in such a trust or transferring the arrangement to a personal pension. This type of planning will succeed only if the member is in good health at the time the transfer is made.
In this context, good health means likely to survive two years. IHT planning through pensions can go much further than this. Pension contributions can be made for, among others, partners, children and grandchildren.
Such contributions have other advantages. The contribution can't be dissipated by an impecunious beneficiary - there is no access until age 55. The formalities of trusts are avoided. Best of all, income tax relief is available on the contribution.
Telling the difference
The position can be summarised as follows:
Maximum contribution £2,880 (grosses to £3,600):
• ‘Safe' until 55
• Bridges retirement savings gap
• Income tax relief
• IHT transfer.
Maximum contribution limited to relevant earnings and available annual allowance:
• ‘Safe' until 55
• Bridges retirement savings gap (low-earning children/grandchildren don't have spare income to make pension contributions)
• Income tax relief
• IHT transfer.
The arguments for contributions apply with even greater force when regular pension contributions can be made. There is no limit to the amounts which can be transferred under the ‘normal expenditure from income' exemption.
This exemption applies where the gifts are unconditional, and it can be proved that the gifts:
• formed part of the donor's usual expenditure
• were made out of income
• left the donor with sufficient income to maintain his/her normal standard of living.
HM Revenue & Customs (HMRC) accepts that even a single gift by way of payment under a deed of covenant or other regular commitment, such as payment of the first of a series of premiums on a life policy, or the first contribution to a pension arrangement may be accepted as "usual".
The amount relievable is limited by the potential donor's "surplus income", but in favourable circumstances significant sums can be passed on in this way.
One traditional form of IHT planning has been the bond-trust arrangement. It is important for one to appreciate why trusts are used in IHT.
At first sight, trusts are unattractive to the planner. Trustees are taxed on income at 50% (42.5% in respect of dividend income), at 28% on capital gains (after a reduced annual exemption compared to an individual) and trigger three IHT charges (on establishment, on ten-yearly anniversaries and on exit).
Why trusts are used
HMRC commissioned a research ¬report entitled Research on Trusts: Experience of Setting up and Running Trusts. The main aim was to gather information on the setting-up and managing trusts from both settlors and trustees.
This involved exploring both the reasons for starting a trust and the processes undertaken, while additionally understanding the impact of the current tax regime on related decisions.
One of the central aims was to understand the motivations of individuals from different socio-economic backgrounds holding assets in trust.
The research found that the main motivation for setting up a trust related to having the ability to control assets.
Examples of controlling assets included: passing them on to children or grandchildren, providing for a beneficiary in a particular way, withholding assets until children reach a certain age, and ensuring that money stays within the ‘bloodline'.
Tax tended to be a secondary motivating element for creating a trust. The trick is to use trusts in conjunction with a suitable financial product and within available exemptions, reliefs and tax bands to minimise or eliminate tax exposure.
A life assurance bond is ideal as a complement to a trust - no income tax until a chargeable event occurs, no capital gains tax is charged and it is transferable by simple assignment. Provided the sums transferred are kept within the available nil-rate band, exemptions and reliefs, the bond-trust combination can be a powerful tool for the planner.
Trusts can be designed to offer a degree of settler access, thus meeting another client need.
Provision for children
It is also worth exploring some of the less well-known and lesser-used IHT exemptions.
There is an IHT exemption for gifts to children and dependent relatives where the gifts are used for maintenance of the recipient, or in the case of children for the recipient's education. The relevant legislation can be found in the 1984 Inheritance Tax Act, section 11.
Consider the case of Susan and Jeremy. Susan is 41 and an unmarried mother. She is terminally ill and has a nine-year-old son, Jeremy. Susan has assets of £1.6m and wants her wealth to support Jeremy. Can she use section 11?
• Setting up a trust for Jeremy's education and maintenance. The capital for this would be the expected costs of his education (which could include university education) and living expenses until his education has finished. This would have to be done with reasonable accuracy. This is not a taxable transfer
• Passing the remaining assets to Jeremy via a will trust, Susan could also consider making pension contributions for Jeremy's benefit, to use up annual exemptions - although this is unlikely to generate large IHT savings in view of her state of health. It would be a taxable transfer, but Susan's nil-rate band would be available.
No discussion of IHT planning would be complete without a discussion of the benefits of marriage or civil partnership.
In the context of IHT, there is a valuable spouse exemption - unlimited where a transferee spouse is UK domiciled, but limited to a lifetime £55,000 otherwise. Spouses can benefit from a transferable nil-rate band.
For those clients with partners rather than spouses, marriage opens up a whole range of further planning options.
Gerry Brown is head of tax and trusts at Prudential
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