UK Inheritance Tax – embracing the long term approach for lasting wealth preservation

Inheritance tax (IHT) in the United Kingdom has long been a subject of both curiosity and concern for families passing down their wealth through generations. In 2023, the UK witnessed a significant milestone as the government reported a record-breaking £2 billion paid in IHT in the period April 2023 to June 2023, an 11% increase on the same period in 2022. This has led to a media storm around the tax with some claiming it is “immoral” and others suggesting that the rich have special tactics not to pay any IHT at all. This shows a wide misconception of the IHT rules and there are a number of misleading statements making headlines which only add to the confusion.

Understanding Inheritance Tax in the UK

Most people are aware that uk inheritance tax is a tax levied on the estate (the property, money, and possessions) of a deceased individual but there are a number of other instances when inheritance tax can be payable. For example, certain gifts during your life can give rise to the lifetime IHT charge and many Trusts pay IHT every ten years and on certain transfers out of the Trust.

Each individual has a threshold allowance against inheritance tax known as the “nil rate band” (NRB) which in 2023/24 is £325,000. Additionally, since April 6 2017, a “residence nil-rate band” (RNRB) has been introduced, allowing individuals to claim an additional tax-free amount for the value of their main residence when passed on to direct descendants, such as children or grandchildren. However, the RNRB is tapered away once your estate is over £2 million.

Once your nil rate band has been used the rate of IHT on death is 40%, the lifetime IHT charge is 20% and the Trust IHT rate every ten years is a maximum of 6%.

Why is IHT increasing if planning is as easy as the media claim?

There has been a significant impact on the number of people being pulled into the IHT net from rising property prices and inflation which is compounded by freezing of the uk inheritance tax nil rate bands and gift exemptions, some of which have not changed since 1981. This is known as fiscal drag created by a static rather than progressive tax rate system.

So as more people find themselves facing IHT bills, the hurdle then is effective IHT planning. The main basis behind IHT planning is that you need to have passed on your wealth and assets, potentially at least seven years before death without retaining free ongoing enjoyment of them for these to be outside of your estate on death. Whatever is claimed online, there is a tight net of legislation designed to foil planning which attempts to circumnavigate this. Added into this is also the fact that transfers which may reduce your estate for IHT purposes may equally give rise to immediate capital gains tax charges or lifetime IHT charges. So pay tax now in order to save IHT later.

Being able to give away assets without future access is a limiting factor for a number of people. With people living active lives much longer and with an eye on being able to afford future care if needed, there is an understandable hesitation to how much of their wealth people are happy to lose complete access to. There is also the concern around losing generational wealth through a child’s divorce where the assets have been passed down without limitation. So, all in all, not as easy as the media claims.

Is a Trust or Family Investment Company the solution?

Placing assets into a Trust can remove them from an individual’s estate, potentially reducing the value of the estate subject to IHT upon death. Additionally, some Trusts offer flexibility and control over how assets are distributed, providing individuals with peace of mind that their wealth will be safeguarded and managed responsibly. However, changes to Trust tax rules in 2006 means that there are restrictions on the value or the type of assets that can be placed in them without attracting an immediate lifetime IHT charge at 20%. It is also essential to remember that there are various types of Trusts, each with its own implications and complexities. In order to be effective, generally you or your spouse cannot be a beneficiary of the Trust. So again, any hesitation around future access to the assets needs to be considered.

The 2006 Trust changes saw the rise in popularity of Family Investment Companies (FIC). FICs are private limited companies set up to hold and manage family wealth, making them an attractive alternative to traditional Trust structures. One of the key reasons for their widespread appeal is their flexibility, allowing families to maintain control over their assets while minimizing IHT liabilities. But this popularity means that HMRC is now looking closely at their set up and there are a number of traps for the unwary.

So while either of these structures can be an effective tool in IHT planning, they are by no means a one-size-fits-all solution. Setting them up requires careful consideration of one’s financial situation, long-term objectives, and the potential impact on beneficiaries. Setting up and managing these structures can involve legal and administrative complexities, which may incur additional costs. It requires careful monitoring and adherence to legal obligations.

The Long-Term Perspective on IHT Planning

Whilst the above may seem quite negative, it doesn’t mean there is nothing you can do. Some aspects of IHT Planning are around ensuring you are qualifying for reliefs you may be entitled to and you are not falling into simple traps which increases the size of your estate.

Our advice is also that IHT planning should not be treated as a quick fix but rather as a gradual, long-term strategy. While it may be tempting to seek immediate solutions to reduce IHT liabilities, a rushed piece-meal approach may overlook crucial elements and lead to unintended consequences for both the individual and their beneficiaries.

Client example: A new client asked to discuss IHT and on an asset review we found she had set up a FIC years earlier which she believed to mean that the assets in the FIC were outside of her estate. However, the FIC had not been correctly implemented so there was no reduction in the estate at all. After further discussions, we were able to take further action to ensure the FIC worked as intended.

My strategy with clients is to maintain an ongoing conversation with a summary of current thoughts and asset analysis regularly reviewed. Working closely with financial advisors for support around future wealth requirements is also helpful as is working with solicitors who can correctly prepare any wills and legal documents.

Client example: we reviewed a client’s will which they had described as ‘mirror wills’ only to find they were not mirror wills at all. Whilst everything was left to the spouse in the first instance in both wills, there were big differences in what would happen in the event of a second death. This difference gave rise to some significant increases in the IHT liability on the second death if it were the husband that died first. We suggested some crucial amendments and supported the client’s discussions around a compromise to reduce the potential IHT leakage if they died in the ‘wrong’ order.

Sometimes small annual planning can cumulatively accrue larger tax benefits – for example making pension contributions for an adult child. When your children start their own families and have increased outgoings their pension contributions may fall by the wayside whereas you could consider stepping in to make their regular contributions. The amount you can pay annually and how it affects your IHT will depend on your circumstances.

This proactive approach to IHT planning allows for adequate time to implement measures, such as lifetime gifting and structuring assets efficiently, without rushing into decisions that may prove less beneficial in the long run. Embracing IHT planning as a sustained process empowers individuals to make informed decisions, protect their assets, and secure a lasting legacy for their loved ones.