Easing the IHT burden

The complexities of modern life can place extra stress on inheritance tax planning says Andy Kirby

Pensions by their very nature are not a standard investment. According to a recent survey1, the average UK citizen begins saving for their retirement when they are 28 years old. At that point, they are diligently putting away money that they won't see again for at least another 27 years. So by any standards, pensions are an investment where any rewards become apparent over the longer term.

Finding an approach for inheritance tax (IHT) mitigation, that includes the family home, is one of the biggest challenges for clients. Giving assets away can be just as fraught, especially if their offspring is facing a messy divorce. However, even though the uses of trusts in connection with the family home have been subject to continued erosion over the decades, a significant amount of protection is still available.

When considering IHT planning two things are important - the nature of the assets and beneficiaries. Over the last 10 years, the nil rate band (NRB) has increased by 45% and currently stands at £312,000 increasing to £325,000 for the 2009/10 tax year.

One of the most common problems in IHT planning is clients wanting to give money away to beneficiaries, but worrying about how their finances will pan out and affect their future plans. Prior to looking at any tax structures, clients should always start with their will and then look at excess liquid assets. The foundation for IHT planning is making best use of the exemptions available, including gifts, followed by the prudent use of other structures in relation to capital, some of which allow continued access to income such as discounted gift trusts.

Unintended consequences

With 45% of marriages now ending in divorce, it is not surprising that your client may be worried about the financial consequences of gifting part of their estate, should one of the beneficiaries have a large divorce settlement to pay. One option would be to put some of the money for beneficiaries into trusts, including discretionary trusts and trusts which give beneficiaries a right to income but not capital. There are also a number of options available in order to safeguard assets and mitigate inheritance tax while still providing the beneficiaries with the financial provision (and protection) intended by the client.

The most straightforward type of trust, but which does not necessarily safeguard capital for beneficiaries over 18, is a 'bare trust'. Here the asset is held in the trustee's name and the beneficiary can have access to both the income and the trust property at any time. It can be used to gift money during the client's lifetime, particularly in favour of minor children. Providing the settlor survives seven years after the transfer is made, there will be no IHT charges on death.

An interest in possession trust entitles the beneficiary to the income and not the property. These types of trusts are commonly used in wills where the partner is entitled to the income, or right of enjoyment, of the trust property and on their death, the trust property passes to the children.

Discretionary trusts allow the trustees to decide how much income or capital to pay to each of the beneficiaries and when. These types of trusts can be used to pass on a property during a lifetime while allowing some control over it through the terms of a trust deed. These were commonly used in wills to utilise both parties' IHT allowances.

However, since the Pre-Budget Report, in October 2007, married couples and civil partners have a combined IHT allowance of £624,000. However, the rules do not apply to unmarried cohabiting couples or relatives living together.

Often, the biggest consideration for clients is what happens if assets are given away for IHT planning purposes and then are needed in the future, for example, to make the home elderly friendly. Loan trusts can be used in this situation as they allow the client to reduce the future value of the estate, thereby reducing the IHT liability, while allowing them access to the capital in the future.

However, the outstanding 'loan' still remains within the value of the estate.

Discounted gift trusts

Discounted gift trusts are also suitable for clients who have surplus capital to which they don't need access to but do need to draw an income.

While transferring capital into trusts can reduce the value of the estate for IHT purposes, the tax implications during lifetime transfers must be considered. Any transfer above the NRB will be charged at 20% on the excess and if the transferor dies within seven years, a further 20% will be charged under the current tax rules.

One of the major obstacles in IHT planning is the family home as for most people it can't simply be given away while continuing to live in it. This is deemed by HMRC as a gift with reservation of benefit and does not remove the house from the estate. The only way to avoid paying pre-owned asset tax would be for a commercial rent to be paid by the benefactor which may have income and capital gains tax implications for the beneficiary.

While the rules are ambiguous, an annual rent of around £50,000 would be expected for a £1million property and the beneficiary would have to pay £20,000 in income tax, assuming they are 40% tax payers. There are financial schemes that have been proved to be effective and have stood up to scrutiny by HMRC, such as a scheme called property wealth manager from Close Investments, but as with all financial solutions appropriate advice needs to be taken.

In short, trusts can still provide effective solutions to wealth management problems - but recent legal precedents mean that they need to be used for specific applications and in many circumstances multiple trusts may be required.