As Benjamin Franklin said, “nothing is certain in life save death and taxes”. Thanks to the government you can have both at the same time, in the form of inheritance tax (IHT).

As you probably know, inheritance tax is payable on the value of your estate (assets minus liabilities) when you die. To make life more complicated, it can also be payable on gifts you make when alive.

IHT is currently (2009-20010 tax year) payable on the value of estates over £325,000 (i.e. no tax on estates less worth than this), and is charged at a flat rate of 40%. If the value of your estate was £500,000 the tax bill would therefore be £70,000.

The important point is that your assets are deemed to include not only possessions, but also any gifts you made within the last 7 years of your life (so that you can't simply give away all your possessions on your death bed). It used to be possible to avoid some tax by giving your house to your children while continuing to live in it, but this now requires careful planning

It appears deceptively simple for your heirs to pay the tax liability by selling some of your assets. However, it is not usually possible to sell assets until Probate (or Letters of Administration) has been granted. This cannot normally be obtained until at least some of the Inheritance Tax liability has been paid.

This is a vicious circle, which may mean that your heirs may have to take out a loan to pay the tax liability. Only when some of the tax has been paid will they have the opportunity to sell some of your assets to pay off the loan. So no matter how much money there is in your estate, the demands of the tax man must always be met first.

Three Steps To The Solution

There are three steps you can take to reduce your potential liability.

1. Draw up a tax efficient Will and consider how ownership of your possessions could be arranged between yourself and your spouse to meet personal requirements and minimise tax liabilities.
2. Make gifts during your lifetime to reduce the value of your estate.
3. Ensure that a fund of money will be available on your death so your beneficiaries can use this to meet the tax liability. The simplest way to do this is with a life assurance policy.

Step One: Wills

The first step is to review your Will to ensure that you are leaving your possessions to your beneficiaries in the most tax efficient way possible. Two important things to bear in mind when reviewing a Will for Inheritance Tax purposes are:

• gifts between a husband and wife (domiciled in the UK), whether during life or on death, are totally free of Inheritance Tax irrespective of the amount.
• gifts to any other individuals, totaling up to the nil rate band, are also free of Inheritance Tax.

It is important to note that for both spouses to take advantage of their individual nil rate bands it is not usually sufficient for them to hold assets jointly, such as a joint building society account. In these circumstances the account would automatically pass into the sole ownership of the survivor on the death of either spouse. So whoever died first could not pass their share of the joint account to their children under their will. Instead each spouse should have their own separate account.

Nil Rate Band Discretionary Will Trusts

This is a method by which full use can be made of the first death nil rate band for Inheritance Tax purposes, reducing the potential liability which exists on second death, whilst maintaining flexibility and giving the survivor access to the capital and/or income generated.

On first death specific legacies are first satisfied and assets to the value of the unused nil rate band are then transferred into a discretionary trust. The trust specifies the category of people who can benefit from the trust, usually the surviving spouse and children. As such, the spouse can receive capital and/or income appointed out of the trust.

It is normal to appoint the surviving spouse as a trustee and at least one other independent trustee should be appointed. The trust assets do not form part of the surviving spouse’s estate.

Any capital appointed out of the trust will, of course form part of the surviving spouse’s estate.

A will allows you to:	Dying without a will means:
decide who gets what, how much and when	the laws of intestacy will dictate who has legal entitlement and how much they will receive
avoid intestacy – if no family members survive you then all of your assets (after the deduction of your liabilities) go to the Crown	Greater stress and delay for those who are appointed by the courts to sort out your affairs
appoint the guardian for your children	the courts will appoint the guardians
appoint executors and trustees to look after assets	the administrators of your estate will decide
you can include provisions to reduce inheritance tax	all adult beneficiaries will need to agree any changes within 2 years and they will need to pay a solicitor to produce a deed of variation
If married, you can choose to use your inheritance tax threshold to reduce your IHT liability	All adult beneficiaries will need to agree any changes within 2 years and they will need to pay a solicitor to produce a deed of variation
decide who will receive specific items e.g. jewellery, antiques, treasured possessions	the administrators of your estate will decide
make gifts to charities	your favourite charities may get nothing
decide if you wish to donate your organs or your body for medical research	others will have to remember your wishes and act on them
decide how your funeral will be conducted	the administrators of your estate will decide

Step Two- Gifts

Gifts between husband and wife

All gifts between husbands and wives resident in the UK are exempt from Inheritance Tax whether they are made during your lifetime or on death.

Gifts between UK domicile and a non-UK spouse have an allowance of the NRB plus £55,000

Annual exemption

Everyone can give away a certain amount each year, free of Inheritance Tax and a married couple can give away twice this amount between them. The rate for the tax year 2009/10 being £3,000.

If you only use part of your exemption in a tax year the remainder can be carried forward for one year only provided that the exemption for the current year is fully used first.

Normal expenditure

Gifts made on a regular basis from income after tax are exempt from Inheritance Tax provided:

• the gift is part of normal expenditure, i.e., it is not a one-off payment but one of a series of regular payments;
• it is made from income not capital;
• after making the gift the person who makes it is left with sufficient income to maintain his/her usual standard of living.

This is an extremely useful exemption which is often overlooked. It enables you, for instance, to make contributions to a life assurance policy which are totally free from Inheritance Tax.

Also, if you make use of this exemption to make regular gifts you can use the annual exemption to cover any one-off gifts you might wish to make.

Charities

All gifts to charities registered in the UK are normally exempt from Inheritance Tax regardless of the amounts given.

Small Gifts

You can make gifts of up to the current limit to as many people as you like. Where an individual gift exceeds this amount the exemption is lost. This exemption cannot be combined with any other to cover a larger gift. The rate for the tax year 2009/10 is £250.

Gifts on marriage

Gifts to a bride and groom on marriage are exempt from Inheritance Tax up to a certain limit depending whether the gifts are made by the parent(s), grandparent(s) or any other person.

If you want to claim this exemption the money must usually change hands on or before the date of the wedding.

This exemption can be used to cover part of a larger gift. By combining this exemption with the annual exemption it is possible to make substantial tax free gifts.

Potentially Exempt Transfers (PETs)

Gifts from one individual to another or into most types of trust if not covered by any exemption, are usually PETs. PETs are not subject to tax at the time they are made and if you make a PET and survive for a further seven years it becomes an exempt gift and no tax is payable on it.

However if you die within seven years of making a PET, Inheritance Tax is calculated according to the tax rates in force at the date of death but based on the value of the PET at the date it was made.

As you may be aware, one way to minimise IHT on your estate is to “gift” money away from you estate, before you die.

You can make one “gift” payment of GBP 3,000 per annum to anybody (your wife or kids for example) without this incurring any IHT (you can back date this one year also).

You can also make “Chargeable Lifetime Transfers” (CLT’s) up to the current NRB, but you must live for 7-years after this, to make them IHT free.

Step 3- Life Cover

A common and simple way to combat IHT is to setup a life assurance policy to cover the amount of the debt. This policy would be held in Trust and can be then used to cover the liability on your estate. Under the new rules, premiums into the policy remain exempt as they will fall under the annual GBP 3,000 limit.

Trusts

Trusts can help in estate planning and are legal arrangements used to pass assets on to a person, or to a group of people (trustees), who look after and manage the assets on the behalf of those named in the trust (the beneficiaries).