FOOL SCHOOL
An Introduction To Inheritance Tax

October 27, 2004

Inheritance Tax (IHT) is the only tax where you do not get to join in personally, on account of the fact that you will have left the party for good if it is payable. Sad, really, to miss out on one final opportunity to pay some tax, possibly the largest amount you will ever have had to pay in one go. Well, do not regret it too much, you will after all have had a lifetime's pleasure of paying Income Tax, maybe some Capital Gains Tax, definitely some Value Added Tax, could be some Corporation Tax, almost certainly some Excise Duties and Stamp Duties and Council Tax. So although you will not be around to witness the payment of IHT, you will have had your fun.

On the face of it, IHT is deceptively simple. Value the individual's estate at death, deduct the 'nil-rate band' (£263,000 for 2004/5) and the balance is taxed at 40%. One exempt band, and one tax rate above that. The definition of the estate is the aggregate of all property to which the person is beneficially entitled. Note that the estate includes chargeable transfers made within seven years of death.

Valuing an estate can become complex. Some assets are fairly easy to value, typically quoted shares. Property is less simple and involves a valuer's opinion with which the Inland Revenue may argue. Similarly, private companies can be even harder to value and often create lengthy arguments with the Revenue.

The main things in which people will be interested are the exemptions and mitigations that arise with this tax. Here is a brief list:

• Transfers between spouses. An estate or part of it left to a spouse is free of IHT. This is the most widely utilised exemption from the tax.
• Gifts to Charities. These are exempt from IHT.
• Annual Gifts. Transfers of up to £3,000 per tax year are exempt. This can be carried forward for one year only.
• Small Gifts. In addition to the above, up to £250 per tax year to any one person are exempt.
• Gifts in consideration of marriage. Up to £5,000 by a parent of either marrying party, £2,500 by a grandparent or remoter ancestor, £1,000 by anybody else are all exempt.

In addition to the above exemptions, two reliefs are available for estates containing business property or agricultural property. These reliefs provide 100% reduction in the tax on those elements of the estate. Very valuable points for those estates containing these assets. There are a whole load of rules on what exactly is meant by business or agricultural property.

If a lifetime gift is made, not covered by the annual limits shown above, then this becomes a potentially exempt transfer (PET). If the donor survives seven years, then it becomes an exempt transfer. PETs are assumed to be exempt at the time of transfer so that no IHT is payable at that point. If the donor dies before the seven year period is up, then there is a tapering rate of IHT payable as follows:

• Under 3 years: 100%
• 3-4 years: 80%
• 4-5 years: 60%
• 5-6 years: 40%
• 6-7 years: 20%

The percentages refer to the proportion of the full rate of IHT payable on the gift, which is valued as at the date of transfer, not the date of death.

What happens if someone dies, pays IHT, the estate is left to another who then dies shortly after? You might be forgiven for assuming that the second estate has to pay all over again. However a reduction called Quick Succession Relief is available, which reduces the tax payable on the second death, according to a tapering scale per year, provided the second death is within five years of the first.

One fairly clear and simple IHT planning possibility is already apparent, if you are married, and it is this:

Estates left to spouses are completely exempt. Thus if one spouse leaves the lot to the other, no IHT arises. Upon the death of the second, IHT kicks in, assuming it is not all left to charity or a new spouse. The nil-rate band is tax free and 40% tax would be due on the rest. Between the two of them, only one nil-rate band would have been realised.

Now supposing that the wills had been drafted a little differently such that upon the first spouse's death, an amount equal to the nil-rate band had been left to the children (or whoever), with the balance to the spouse. The amount left to the spouse is tax-free. The amount left to the children is also tax-free, because it is covered by the nil-rate band. Upon the second death, that spouse also has a nil-rate band before any tax is payable. Thus, with this simple device, it's been possible to make use of two nil-rate bands as opposed to just the one.

It does, of course, depend upon the surviving spouse having sufficient to live on, even after the nil-rate band has been bequeathed by the first spouse to die, to their children or whoever. To that extent it favours the more wealthy against the less-wealthy-but-still-worth-a-few-bob.

It is possible by using the spouse exemption for IHT never to be paid at all. The condition is that the surviving spouse in each case goes on to remarry and that he or she leaves the estate, or all of it bar the exemption, to the new spouse. By continually remarrying, no tax is ever paid. The children if any may get a bit peeved by this though... however it is a great incentive for prospective toy boys or girls.

And that is it for a very brief and simplified look at this tax. We have avoided mention of the use of trusts as being beyond the scope of this article.

People need to make wills because for those left behind, it can be an awful mess if you don't. In addition, if your estate is sufficiently large and you wish to mitigate IHT, we advise strongly that you consult an accountant or lawyer specialising in this subject. This is not an area for the DIY person. Our Wills & Probate Guide should help you with an overview though.