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There’s more to estate planning than gifting

20 December 2020

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Making lifetime gifts to plan for inheritance tax is permanent and irreversible, but it’s not the only way, says Jessica Franks, Head of Tax, Octopus Investments

If you’ve helped a client plan for inheritance tax, as many of you will have, then you’ll recognise the typical reluctance from clients to give away wealth in their lifetime.

Despite the amount of assets and potential tax liability involved, many clients feel uncomfortable exploring the opportunities to reduce inheritance tax because they fear the only way to do so is by giving away assets.

Gifting is a traditional solution to passing down wealth, and often the only option a client will be familiar with. However, the complex rules around gifting can be an immediate put off for clients. And those clients who want to retain control of their money as they enter their twilight years can be put off estate planning altogether.

As an adviser, that is not where your conversation has to end. For the right client, there is a blended approach that can offer a way forward.

The basics of gifting

Any individual with an estate value above the nil-rate band of £325,000 will be subject to 40% inheritance tax. In some cases, the residence nil-rate band of £175,000, which offers a tax-free transition of a personal residence to a child or grandchild, will raise that overall personal allowance to £500,000.

Beyond this, assets can be given away as a ‘gift’, but there are limitations and pitfalls to be aware of.

Any gifts between spouses or civil partners are free from inheritance tax. For passing wealth to people other than a spouse or civil partner, there is an annual gifting allowance of £3,000, which can be carried over for a year if only partially or fully unused. There is also allowance for wedding-related gifting, limited to £5,000 for children and £2,500 for grandchildren, and gifts to charities, national museums, universities, the National Trust, political parties and some other institutions.

The limits of gifting

As mentioned, some gifts are always tax free, but most are classified as ‘potentially exempt transfers’. These typically become free from inheritance tax once the person making the gift survives for seven years after the gift is made, with a tapering scale of relief covering that gift in excess of the nil rate band if they do not.

The major problem with this for many clients is that gifting is permanent and irreversible. Anyone making gifts loses ownership and control of their wealth as soon as the gift is made.

As nobody can know what the future might hold, and how much money you might need, making a gift can feel like a drastic way of reducing an inheritance tax liability.

Additionally, seven years can be a long time to be certain a gift has worked as intended, especially if a client is elderly or in poor health.

The flexible alternative

Fortunately, for some there is a way around this challenge. Investments expected to qualify for Business Property Relief (BPR) offer relief from inheritance tax, and are now an essential tool in many advisers’ armoury.

These investments stay in the client’s name, directly addressing that gifting reluctance, and can be left to their beneficiaries free from inheritance tax.

Unlike a gift, the investor retains control of the investment and can request to sell it (or part of it) whenever they need or wish to, although proceeds of sale will no longer be exempt from inheritance tax. Bear in mind that liquidity can never be guaranteed.

Instead of taking seven years to become exempt from inheritance tax, shares in a BPR-qualifying company need only be held for two years and still be held at the time of the investor’s death to be passed on to beneficiaries free of inheritance tax. And should the investor die within those two years, the investment can be transferred to their surviving spouse or civil partner without resetting the two-year clock.

BPR was introduced as part of the 1976 Finance Act, to allow small businesses to be passed down through generations without beneficiaries needing to sell the business to cover a large inheritance tax bill. Over time, successive governments have recognised the value of a tax relief that encourages people to invest in trading businesses, regardless of whether they run the business themselves.

Inheritance tax services build portfolios of investments in BPR-qualifying unquoted trading companies, or companies listed on the Alternative Investment Market (AIM). The tax incentives exist to compensate for some of the additional risks associated with investing in such companies.

Mix and match

Of course, BPR-qualifying investments won’t be suitable for every client, but that is where adviser expertise comes into play.

By assessing the estate as a whole, and evaluating the overall liability to inheritance tax, a blend of BPR, gifting and other strategies can deliver the ideal solution for a suitable client.

Clients need to be aware of the risks as the value of a BPR-qualifying investment, and any income from it, can fall as well as rise and investors may not get back the full amount they invest. The shares of AIM-listed and unquoted companies could fall or rise in value more than shares listed on the main market of the London Stock Exchange. They may also be harder to sell.

It is important to also understand that tax treatment depends on individual circumstances and tax rules could change in the future. The availability of tax relief depends on portfolio companies maintaining their qualifying status.

When positioned alongside gifting as part of an estate planning strategy, BPR-qualifying investments could help clients minimise inheritance tax without having to give everything away in their lifetime.

Watch the latest Octopus online show on estate planning on demand to learn more about BPR and the types of clients it could be suitable for.

Professional Paraplanner