IHT - What a palaver! Let's have a look.

Inheritance Tax impacts a tiny percentage of individuals, however, seems to exercise a large number of those who are past masters at avoiding tax or finding loopholes. So I thought I would look at the area and even offer some advice to those lucky few.

 

The Economic Argument: Revenue and Efficiency

• Source of Government Revenue: IHT raises significant revenue for the Treasury—approximately £7.1 billion in 2022/23—which contributes to funding public services like the NHS, education, and infrastructure. While this is a small fraction of total tax revenue (~0.8%), it is a meaningful sum.
• Economically Efficient Tax: Many economists argue that IHT is one of the most efficient taxes from a behavioural perspective. Unlike taxes on income or corporate profits, which can discourage work and investment, taxing accumulated wealth after death is thought to have less of a distorting effect on a person's economic decisions during their lifetime.
• Encouraging Productive Use of Capital: The threat of IHT can incentivise older generations to spend their wealth or donate it to charity during their lifetime, which can stimulate economic activity. Alternatively, it can encourage them to invest in assets that qualify for Business Relief, thereby supporting productive businesses and assets within the economy.

The Ethical Argument: Redistribution and Fairness

• Progressive Taxation: IHT is a highly progressive tax. It is paid exclusively by the wealthiest households (affecting only the top ~4% of estates). It targets unearned windfall gains for recipients, which many view as a fairer subject of taxation than earned income from labour.
• Redistributive Function: The tax is a key tool for redistribution. The revenue collected is pooled and can be used for public services that benefit society, creating a greater net benefit than if the money remained within a single wealthy family.

Meritocracy and Equality of Opportunity

This is an  ideological argument supporting IHT.

• Preventing an Aristocracy of Wealth: Proponents argue that large, unearned inheritances can create and perpetuate dynastic wealth, where life outcomes are determined by birth rather than merit, talent, or hard work. IHT acts as a "meritocratic brake" on this process.
• Promoting a Level Playing Field: The tax is seen as a tool to promote a more equal starting point for individuals. By taxing large transfers of wealth between generations, it aims to reduce the advantages that heirs to large fortunes have over those who inherit little or nothing, fostering a society where success is theoretically more based on individual effort.

The Practical Argument: The "Least Bad" Option

• Hard to Avoid Paying Altogether: While there are legal ways to mitigate IHT (I will suggest a few), it is difficult for individuals to avoid paying some form of tax on their wealth during their lifetime or at death. Compared to other wealth taxes, IHT is a practical method of taxing large accumulations of capital.
• Alternative Taxes Could Be Worse: From a Governments perspective, if IHT were abolished, the lost revenue would need to be recovered elsewhere. This could mean increases in other, potentially less popular, or less fair taxes, such as Income Tax, VAT, or National Insurance, which would affect a much broader segment of the population.

The Societal Argument: Encouraging Philanthropy

• Stimulating Charitable Giving: The IHT system includes significant incentives for leaving money to charity. Gifts to charity are exempt from IHT, and if you leave 10% or more of your estate to charity, the rate of IHT on the remainder drops from 40% to 36%. This is a powerful policy tool designed to foster a culture of philanthropy and support the vital charitable sector.

The anti-iht lobby indignantly make three main arguments

• "It's Double Taxation!": The common argument that the money was already taxed as income is often rebutted by pointing out that all money is taxed multiple times (e.g., income is taxed, then VAT is paid when it is spent). The estate is a new transfer of wealth to a new owner (the heir), and it is this transfer that is being taxed, not the original income.
• "It's Unfair to Savers!": The counterargument is that the tax specifically protects savers of modest means through the £325,000+ Nil-Rate Band and the main residence allowance. It deliberately targets only the largest estates.
• "It's Complex and Easy for the Wealthy to Avoid!": Advocates agree that the system is complex but argue the solution is not abolition, but reform. They suggest simplifying the rules, tightening loopholes, and making the tax harder to avoid for the ultra-wealthy so it better fulfils its intended purpose.

In summary, the case for Inheritance Tax rests on the belief that it is a necessary and fair tool to promote social mobility, fund public services through a progressive tax on unearned wealth and encourage positive economic and philanthropic behaviour. The debate continues as to whether it successfully achieves these goals in its current form.

However, most surprising of all. Is that no one steps forward and says. “Why don’t you manage your estate better”

 

 Understanding the Basics First

Before you can plan to legally avoid IHT, you need to understand what it is:

• IHT Rate: 40% on the value of your estate above a certain threshold.
• Nil-Rate Band (NRB): The threshold is £325,000 per person. This is the amount you can leave behind before IHT is due.
• Residence Nil-Rate Band (RNRB): An additional £175,000 per person (2023/24 tax year) is available if you leave your main residence to direct descendants (children, grandchildren, etc.). This is subject to tapering for estates valued over £2 million.
• Transferable Nil-Rate Band: Unused NRB and RNRB can be transferred to a surviving spouse or civil partner. This means a married couple/civil partnership can potentially leave up to £1,000,000 (£325,000 + £325,000 + £175,000 + £175,000) free of IHT.

Strategies to Legally Reduce Your IHT Liability

The core principle of IHT planning is to reduce the value of your taxable estate during your lifetime, while you are fit and healthy, through gifts and other financial arrangements.

1. Make Use of Exemptions (The Easiest Starting Point)

You can make gifts out of your regular income and capital without incurring an IHT liability, provided you follow the rules.

• Annual Exemption: You can give away £3,000 per tax year. This can be carried forward one year if unused, allowing a maximum gift of £6,000 in one year.
• Small Gifts Exemption: You can give £250 per person to as many individuals as you like each tax year.
• Gifts from Income: This is a powerful but often overlooked exemption. You can make regular gifts out of your income (not capital) that do not affect your standard of living. Examples include paying a life insurance premium for a child or making regular contributions to a savings account for a grandchild. Detailed records are essential.
• Wedding/Civil Ceremony Gifts:
• £5,000 to a child
• £2,500 to a grandchild or great-grandchild
• £1,000 to anyone else
• Gifts to Charities and Political Parties: These are always exempt from IHT.

2. Make Potentially Exempt Transfers (PETs)

This is one of the most common methods. Any gift you make to another individual is a Potentially Exempt Transfer (PET).

• How it works: The gift is completely free of IHT provided you live for 7 years after making it.
• Taper Relief: If you die between 3 and 7 years after making the gift, the tax on it is reduced on a sliding scale (taper relief). The gift itself is tax-free after 7 years.
• Important: You must give up all rights to the asset. You cannot, for example, give away your house but continue to live in it without paying a market rent (see "Gift with Reservation of Benefit" below).

3. Utilise Your Spouse/Civil Partner Exemption

Transfers of assets between UK-domiciled spouses/civil partners are completely free of IHT at any time, whether during your lifetime or on death. This is why it is crucial to ensure both partners' Nil-Rate Bands are used effectively. Often, assets are left entirely to the surviving partner, meaning the first partner's NRB and RNRB go unused.

4. Leave a Legacy to Charity

If you leave 10% or more of your net estate to charity, the rate of IHT on the rest of your estate drops from 40% to 36%. This can be a significant saving for larger estates and a way to support causes you care about.

5. Take Out a Life Insurance Policy

• You can take out a whole-of-life insurance policy written in trust.
• The policy pays out on your death and provides a lump sum specifically to help your beneficiaries pay the IHT bill.
• Crucially, because the policy is written in trust, the payout does not form part of your estate and is therefore itself free from IHT. The premiums you pay must be affordable and fall under your "gifts from income" exemption.

6. Trusts

Trusts are more complex and require professional advice, but they can be very effective tools.

• Bare Trusts: Often used for minors. The assets belong to the beneficiary absolutely once they are eighteen.
• Interest in Possession Trusts: The beneficiary has a right to the income generated by the trust assets.
• Discretionary Trusts: The trustees decide how and when to distribute the capital and income to a class of beneficiaries.
• Key Point: When you place assets into a trust, it is a chargeable lifetime transfer for IHT purposes. There may be IHT charges at the point of transfer, on every 10-year anniversary of the trust, and when capital is distributed. They are not a simple solution.

7. Business and Agricultural Relief

These are very valuable reliefs for those who qualify.

• Business Relief (BR): Allows you to pass on some business assets at a reduced IHT rate (100% or 50% relief). This can apply to shares in an unlisted company, machinery, or a business itself.
• Agricultural Relief (AR): Offers 100% or 50% relief on the agricultural value of farmland and farm buildings that have been owned and used for farming for a certain period.

 

Crucial Pitfalls to Avoid

• Gift with Reservation of Benefit (GROB): This is a critical rule. If you give an asset away but continue to benefit from it (e.g., you give your house to your children but continue to live in it rent-free), it will still be treated as part of your estate for IHT purposes. To avoid this, you must pay a market rent for the benefit you retain.
• Deprivation of Assets: If you give away assets deliberately to avoid paying for care home fees, your local authority may challenge this and still treat the assets as yours for means-testing purposes. IHT planning and care fee planning can sometimes conflict.
• Capital Gains Tax (CGT): Giving away an asset that has increased in value (like a second property or shares) may trigger a CGT liability for you, based on the market value at the time of the gift. This can sometimes be more immediate than a potential future IHT bill.

Summary: A Step-by-Step Approach

1. Get Professional Advice: This is the most important step. Speak to an independent financial adviser and a solicitor who specialises in estate planning.
2. Write a Will: Ensure your assets are distributed according to your wishes and that you make full use of all available allowances, especially the transferable nil-rate bands between spouses.
3. Use Your Allowances: Systematically use your annual £3,000, small gift, and wedding gift exemptions every year.
4. Consider PETs: Make larger gifts early, understanding the 7-year rule. The sooner you give, the higher the chance of surviving the period.
5. Review Your Estate: Look at assets that qualify for Business or Agricultural Relief.
6. Consider Life Insurance: Protect your beneficiaries from a future tax bill with a policy written in trust.
7. Keep Records: Maintain detailed records of all gifts, dates, and values. This will make it much easier for your executors to manage your estate.

Effective IHT planning is a long-term process, not a last-minute action. The best time to start is now.