Today’s blog explains how Britain’s most hated tax – inheritance tax – works for married couples and civil partners.

Inheritance tax and spouses and civil partners

Special rules apply for inheritance tax purposes to married couples and civil partners. To ensure valuable tax reliefs are not lost, it is beneficial to consider the combined position, rather than dealing with each individual separately. Married couples and civil partners benefit from exemptions that are not available to unmarried couples.

Inter-spouse exemption

The main inheritance tax benefit of being married or in a civil partnership is the inter-spouse exemption. Transfers between married couples and civil partners are not subject to inheritance tax. This applies both to lifetime transfers and to those made on death.

The inter-spouse exemption makes it possible for the first spouse or civil partner to die to leave their entire estate to their partner without triggering an IHT liability, regardless of whether it exceeds the nil rate band.

Transferable nil rate band

The proportion of the nil rate band that is unused on the death of the first spouse or civil partner can be used by the surviving partner on his or her death. This makes tax planning easier and there is no panic about each spouse using their own nil rate band. If the entire estate is left to the spouse on the first death, on the death of the surviving spouse or civil partner, there will be two nil rate bands to play with.

If the first spouse or civil partner to die has used some of their nil rate band, for example, to leave part of their estate to their children, the surviving spouse or civil partner can utilise the remaining portion. It should be noticed it is the unused percentage that is transferred, rather than the absolute amount unused at the time of the first death – this provides an automatic uplift for increases in the nil rate band.

The nil rate band is currently £325,000.

Residence nil rate band

The residence nil rate band (RNRB) is an additional nil rate band which is available where a main residence is left to a direct descendant. It is set at £150,000 for 2019/20, and will increase to £175,000 for 2020/21. The RNRB is reduced by £1 for every £2 by which the value of the estate exceeds £2 million.

As with the nil rate band, the unused proportion of the RNRB can be transferred to the surviving spouse.

Example

George and Maud have been married for over 50 years. Maud died in 2017 leaving £32,500 to each of her two children. The remainder of her estate, including her share of the family home, was left to her husband George.

George dies in July 2019. At the time of his death, his estate was worth £780,000 and included the family home, valued at £550,000, which was left equally to the couple’s children, Paul and Joanna.

At the time of her death Maud had used up £65,000 of her nil rate band. The nil rate band at the time of her death was £325,000. The transfer to George was covered by the inter-spouse exemption and was free from inheritance tax. Maud has used up £65,000 of her nil rate band (20%), leaving 80% unused. She has not used her RNRB band as she left her share of her main residence to George.

On George’s death, the executors can claim the unused portion of Maud’s nil rate band and RBRB. The nil rate bands available to George are as follows:

Nil rate bands £
George’s nil rate band 325,000
George’s RNRB 150,000
Unused portion of Maud’s nil rate band (80% of £325,000) 260,000
Unused proportion of Maud’s RNRB (100% of £150,000) 150,000
Total £885,000

As George’s estate on death is less than the available nil rate bands, no inheritance tax is payable.

Partner note: IHTA 1984, ss. 8A, 18.

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For grandparents wanting to help out their children or grandchildren, habitual gifts can be made free of inheritance tax. Read more on our blog post.

Give from income to save inheritance tax

Within a family scenario, there are many situations in which one family member may make a gift to other family members. However, the way in which gifts are funded and made can make a significant difference to the way in which they are treated for inheritance tax purposes.

Not all gifts are equal

There is no inheritance tax to pay on gifts between spouses and civil partners. A person can make as many lifetime gifts to their spouse or civil partner as they wish (as long as they live in the UK permanently). There is no cap on the value of the gifts either.

Other gifts may escape inheritance tax if they are covered by an exemption. This may be the annual exemption (set at £3,000 per tax year), or a specific exemption such as that for gifts on the occasion of a marriage or civil partnership or the exemption for ‘gifts out of income’.

Gifts that are not covered by an exemption will counts towards the estate for inheritance tax purposes and, if the donor fails to survive for at least seven years from the date on which the gift was made, may suffer an inheritance tax bill if the nil rate band (currently £325,000) has been used up.

Gifts from income

The exemption for ‘normal expenditure out of income’ is a useful exemption. The exemption applies where the gift:

  • formed part of the taxpayer’s normal expenditure;
  • was made out of income; and
  • left the transferor with enough income for them to maintain their normal standard of living.

All of the conditions must be met for the exemption to apply. Where it does, there is no requirement for the donor to survive seven years to take the gift out the IHT net.

What counts as ‘normal’ expenditure?

For the purposes of the exemption, HMRC interpret ‘normal’ as being normal for the transferor, rather than normal for the ‘average person’.

To meet this condition it is sensible to establish a regular pattern of giving –for example, by setting up a standing order to give a regular monthly sum to the recipient. It is also possible that a single gift may qualify for the exemption if the intention is for it to be the first of a series of gifts, and this can be demonstrated. Likewise, regular gifts may not qualify if they are not made from income.

In deciding whether a gift constitutes normal expenditure from income, HMRC will consider a number of factors, including:

  • the frequency of the gift;
  • the amount;
  • the identity of the recipient; and
  • the reason for the gift.

The amount of the gift is an important factor – to meet the test the gifts must be similar in amount, although they do not have to be identical. Where the gift is made by reference to a source of income that is variable, such as dividends from shares, the amount of the gift may vary without jeopardising the exemption.

Gifts will normally be in the form of money to the recipient, or a payment on the recipient’s behalf, such as school fees or a mortgage. The reason for making a gift may indicate whether it is made habitually – for example, a grandparent may makes a gift to a grandchild at the start of each university term to help with living costs. It is also important that having made the gift, the donor has sufficient income left to maintain his or her lifestyle.

When making gifts from income, check that they may meet the conditions to ensure that the exemption is available.

Partner note: IHTA 1984, s. 21.

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Give to charity to reduce your inheritance tax bill

Making gifts to charity can be an effective way to reduce the amount of inheritance tax (IHT) payable on your estate. Charitable gifts can work to reduce the IHT payable in two ways:

  • reducing the value of the net estate chargeable to IHT; or
  • where the gifts to charity are worth at least 10% of the net estate at death, reducing the rate at which inheritance tax is payable.

Lifetime gifts and bequests on death made to qualifying charities and registered housing associations are exempt from inheritance tax, provided that the gift was made outright.

Qualifying charities

A qualifying charity is one that meets the following conditions:

  • it is a charity that is established in the EU or other specified country;
  • it meets the definition of a charity under the law of England and Wales;
  • it is regulated in the country of establishment, if that is a requirement of that country;
  • its managers are fit and proper persons to be managers of the charity.

HMRC assumes that people appointed by charities are fit and proper persons unless they hold information to show otherwise.

Reducing the net estate

Where a gift is made to charity, the net estate is reduced by the amount of the gift. This can be effective in reducing the amount of inheritance tax payable where the value of the estate exceeds the nil rate band (currently £325,000), plus the residence nil rate band, where available.

The gift to charity reduces the net value of the estate.

Example

Elsie died on 1 December 2018 leaving an estate worth £475,000. She had never married and had no children. In her will she left £5,000 to a qualifying charity, and the balance of her estate to her niece Susan.

Her total estate of £475,000 is reduced by the charitable gift to £470,000. After deducting her nil rate band of £325,000, her taxable estate is £145,000 (on which IHT of £58,000 (£145,000 @ 40%) is payable. The charitable gift reduced the IHT payable on her estate by £2,000 (£5,000 @ 40%).

A reduced rate of IHT

Where the charitable gift is at least 10% of the net estate, the rate of inheritance tax is reduced from 40% to 36%. The net estate is the value of the estate after deducting any debts, liabilities, reliefs and exemptions and the nil rate band and residence nil rate band, as appropriate.

Example

Alfred died on 20 October 2018. He left an estate of £700,000. He had never married and had no children. In his will he left £40,000 to a qualifying charity, with the balance of his estate split equally between his three nephews.

Total estate £700,000
Less: qualifying donation to charity (£40,000)
  £660,000
Less: nil rate band (£325,000)
Taxable estate £335,000

The value of the estate in excess of the nil rate band is £375,000 (£700,000 – £325,000). This is the baseline amount. The qualifying donation to charity of £40,000 is more than 10% of this amount. Thus, the rate of inheritance tax on the taxable estate is reduced from 40% to 36%.

Consequently, the inheritance tax payable on Alfred’s estate is £120,600 (£335,000 @ 36%).

Complications

Where the residue of the estate is partially exempt, for example if it left to a surviving spouse or to a charity, and the Will contains other legacies are left free of tax, it is necessary to gross up such legacies when testing whether the 10% test is met. HMRC produce a calculator which can be used to check whether the test is met. It is available on the Gov.uk website at www.gov.uk/inheritance-tax-reduced-rate-calculator.

Year-end tax planning tips

As the end of the 2018/19 tax year approaches, it is worthwhile taking time for some last-minute tax planning. Here are some simple tips that may save you money.

  1. Preserve your personal allowance: the personal allowance is reduced by £1 for every £2 by which income exceeds £100,000. For 2018/19, the personal tax allowance is £11,850, meaning that it is lost entirely once income exceeds £123,700. Where income falls between £100,000 and £123,700, the effect of the taper means that the marginal rate of tax is a whopping 60%. Where income is over £100,000, consider making pension contributions or charitable donations to reduce income and preserve the personal allowance. Where this is an option, consider also deferring income until after 6 April 2019 to reduce 2018/19 income.
  2. Claim the marriage allowance: the marriage allowance can save a couple tax of £238 in 2018/19. Where an individual is unable to utilise their personal allowance, they can make use of the marriage allowance to transfer 10% of their personal allowance (rounded up to the nearest £10) to their spouse or civil partner, as long as neither pay tax at the higher or additional rate. The marriage allowance must be claimed.
  3. Pay dividends to use up the dividend allowance: family and personal companies with sufficient retained profits should consider paying dividends to shareholders who have not yet used up their dividend allowance for 2018/19. The dividend allowance is set at £2,000 and is available to all individuals, regardless of the rate at which they pay tax. The use of an alphabet share structure enables individuals to tailor dividend payments according to the individual’s circumstances.
  4. Make pension contributions: tax relieved pension contributions can be made up to 100% of earnings, capped at the level of the annual allowance. The annual allowance is set at £40,000 for 2018/19 (subject to the reduction for high earners). Where the annual allowance is not used up in year, it can be carried forward for up to three years.
  5. Transfer income-earning assets to a spouse or civil partner: where one spouse or civil partner has unused personal allowances or has not fully utilised their basic rate band, considering transferring income earning assets into their name to reduce the combined tax liability (but non-tax considerations such as loss of ownership should be taken into account).
  6. Put assets in joint name prior to sale: spouses and civil partners can transfer assets between them at a value that gives rise to neither a gain nor a loss. This can be useful prior to selling an asset which will realise a gain in order to take advantage of both partners’ annual exempt amount for capital gains tax purposes.
  7. Make gifts for inheritance tax purposes: individuals have an annual exemption for inheritance tax of £3,000, allowing them to make gifts free of inheritance tax each year. Where the allowance is not used, it can be carried forward to the next year, but is then lost.

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