Inheritance tax planning - A simple strategy for effective mitigation

With this in mind, in this article I will outline a simple seven-step strategy that can be followed, regardless of estate value or composition, to help those facing liabilities to maximise the amount that passes to their heirs upon their death.

Step 1 - Tax-efficient Wills

The first step in any estate planning strategy should be to ensure not only that tax-efficient Wills are in place, but that these are reviewed regularly to take account of legislative as well as circumstantial changes. For example, a Will drafted prior to April 2017 may include provisions that are incompatible with the residence nil rate band such as a gift of the home (or residue including the home) to a discretionary trust or to grandchildren on reaching a specified age. Recommending that clients review and update their Wills as a first step in an estate planning exercise not helps build connections and trust, it also can also achieve significant inheritance tax savings without comprising access to property and investments during lifetime. Many clients with joint estates that are above or approaching £2m do not, for example, recognise the potential benefit of leaving an amount up to the nil rate band to a trust on first death – yet this will reduce the amount passing to the surviving spouse and help to keep the joint estate on second death down to below the £2m figure above which valuable residence nil rate band starts to be lost. Married clients with business assets that are likely to be sold after death, as well as those who have previously been widowed, may also be able t to make significant IHT-savings by leaving business assets and/or nil rate sums to a trust on first death.

Step 2 - Deeds of variation

Receiving an inheritance can often create or aggravate an existing inheritance tax problem. In this scenario, deeds of variation offer a solution that is superior to any other form of planning. Usually where a substantial gift is made, the gift will constitute a potentially exempt transfer (if made outright) or chargeable lifetime transfer (if made to a trust) that must be survived by seven years for an inheritance tax benefit to be obtained. In addition, it is not possible (unless a sophisticated packaged scheme is used – see step 5. below) for the donor or settlor to retain any benefit in the gifted sum or asset without this being a ‘gift with reservation’. If, however, property or funds that derive from an inheritance are gifted within 2 years of the death and certain prescribed formalities are adhered to, the gift is treated for IHT purposes as if it had been made by the deceased. This means that not only is the estate of the original beneficiary reduced immediately by the full amount of the gift (i.e. no requirement to survive 7 years); if the gift is made to a trust, the original beneficiary can be included as a possible beneficiary under the deed of variation trust – and so retain full access to their inheritance – without any gift with reservation issues. The planning opportunity will be lost once the two-year period has expired though – so it is vital to act quickly where this opportunity presents itself.

Step 3 - Maximise use of IHT exemptions

There are a number of exemptions from IHT which enable gifts to be made that leave the estate immediately and do not impact on other planning. The most well-known of these are the annual exemption of £3,000; and the normal expenditure out of income exemption which allows an individual to regularly give away surplus earned or investment income without restriction provided that certain conditions are satisfied. This second exemption is particularly valuable as there is no cap on how much can be given and the amounts gifted can vary from year to year as long as some sort of pattern can be demonstrated. This could, for example, be something as simple as the client resolving to give away “a third of my rental income each year” or “the annual dividend income paid on my shares in XYZCo Ltd”. Alternatively, the pattern could be linked to regularly occurring events such as grandchildren’s birthdays or payment of school fees or life insurance premiums. It is, however, important that the donor does not have to resort to capital (such as withdrawals from an investment bond) to maintain his standard of living having given away income otherwise the exemption will be denied and the gifts will be treated as PETs or chargeable transfers as appropriate.

Step 4 - Make larger gifts out of capital

Gifts that do not fall within one of the exemptions from inheritance tax will be either potentially exempt or chargeable depending on whether they are made directly to another individual or via a trust. Either way, for a gift to be treated as made ‘outright’ – and so be effective for inheritance tax purposes - it will be important that the donor can comfortably afford to make the gift in the knowledge that he or she will not be able to access the gifted funds if circumstances change. Where a gift is made directly to another individual (or via an absolute trust) it will be a potentially exempt transfer (PET). PETs leave the estate after 7 years and will never give rise to an immediate liability to inheritance tax when made, whatever the value. They can however impact on the nil rate band available to estate as well as on the nil rate band available to a later created trust if not survived by 7-years.

Clients who are happy to give up access to some of their wealth but are not comfortable about giving their intended beneficiaries unfettered access to large sums, may prefer to make gifts via a discretionary trust. Again, the gifted amount will be fully outside the estate after 7 years, however, unlike with a PET, there could be an immediate liability to inheritance tax at the lifetime (20%) rate if the amount gifted exceeds the settlor’s available nil rate band. In addition, discretionary trusts will be subject to the ‘relevant property regime’ of ten-yearly (periodic) and inheritance tax exit charges. Although such charges will in most cases not apply to smaller trust funds, it is vital that prospective settlors seek tax guidance before setting up discretionary trusts to ensure that full account is taken of other planning (such as earlier chargeable transfers or even PETs) that could impact on the likelihood and size of charges going forward. With proper advice, measures can be taken that will help to mitigate or even avoid these charges while ensuring that the client’s overriding objectives for control are met.

Step 5 - Consider packaged schemes for IHT-efficient access

Where there is a reluctance to make outright gifts to trust or otherwise due to a (potential) need for access to investments, there are a number of life-insurance based schemes that are based on established inheritance tax principles which are acceptable to HMRC and which are available from most product providers at no cost. The most popular examples of these are the Loan Plan and the Discounted Gift Trust.

Generally speaking, the Loan Trust is most suitable for clients who are looking for flexible ad-hoc access to their original capital in return for moderate inheritance tax rewards: the investment amount will initially be frozen at its original value for inheritance tax purposes but will reduce to the extent that loan repayments are taken and spent during lifetime; while the Discounted Gift Trust provides the settlor with regular cash payments at a fixed, pre-determined level with no ad-hoc access to the rest of the investment in return for an immediate reduction in the estate for inheritance tax, with the entire investment inheritance tax-free after 7 years.

Step 6 – Invest in relievable assets

Business relief investments can offer an alternative to packaged schemes for experienced investors who are seeking inheritance tax efficiency without compromising their access to their investments. But it’s important to remember that business relief investments are included in the estate for the purpose of determining eligibility for the residence nil rate band so arguably should be considered either where gifting to bring the estate value down to below £2m has already been carried out; or where the estate is of such a high value that gifting to bring the estate down to below £2m isn’t going to be a viable option.  The outcome of owning assets that qualify for business relief is that after a qualifying ownership period of just two years, the assets are effectively excluded from the calculation for inheritance tax purposes with no loss of access and no requirement for a trust to be wrapped around the investments. These investments may have particular appeal to those who do not expect to survive the 7-year gift period however it should be noted that with effect form 6 April 2026, business relief at 100% will be capped at £1m with investments over that value eligible for relief at the lower 50% rate only. AIM shares will also attract relief at just 50% for deaths on or after 6 April 2026.

Step 7 - Consider whole of life insurance to fund any residual liability

If having worked through the above six steps in the strategy and either implemented or discounted taking action at each stage, those facing an inheritance tax liability upon their death may wish to consider funding for any residual liability with life insurance. Depending on age and state of health of the life/lives to be assured, a life insurance plan written in trust can provide a cost-effective solution to an inheritance tax problem, especially in cases where there is no viable way to reduce the estate – perhaps because it is largely tied up in property or other assets standing at a significant capital gain. Premium payments will be treated as gifts to the trust but if these can be funded out of surplus income, these will usually fall within the normal expenditure out of income exemption for inheritance tax meaning that they will leave the estate immediately and not impact on any other planning.

Conclusion

Frozen thresholds and forthcoming tax changes will mean even greater numbers of clients will be seeking advice on how to reduce or plan for their inheritance tax liabilities. Whether it’s possible to carry out planning at every step or most of the steps are unviable or have already been considered and either implemented or ruled out; this simple seven-step approach to inheritance tax mitigation can serve as a useful aid-memoir when structuring inheritance tax mitigation solutions - regardless of estate size or composition.