Grants of representation - Methods of funding initial Inheritance Tax payment

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Overview

Understanding how to fund initial Inheritance Tax (IHT) payments is essential in estate administration and important for the SQE1 FLK2 exam. This article examines strategies to manage IHT liabilities effectively while securing grants of representation. We'll explore the legal framework, planning techniques, and practical applications necessary for aspiring solicitors. By understanding these complex methods, candidates will be well-prepared for estate planning and tax mitigation in their future legal careers.

The Inheritance Tax Framework

Legal Basis and Principles

The Inheritance Tax Act 1984 (IHTA 1984) establishes the rules for IHT in the UK. Section 1 of the Act defines IHT as a charge on the value transferred by a chargeable transfer, including transfers on death. Understanding this framework is essential for identifying potential tax liabilities and developing strategies to reduce them.

The Nil Rate Band and Its Use

The nil rate band (NRB), currently £325,000 (as of 2023/24), is a threshold below which no IHT is due. This allowance is central to IHT planning:

  1. Transferability: Section 8A IHTA 1984 permits transferring unused NRB between spouses or civil partners, potentially increasing the allowance to £650,000.

  2. Residence Nil Rate Band (RNRB): Introduced by the Finance (No. 2) Act 2015, this additional allowance applies when a residence is passed to direct descendants, providing up to £175,000 (2023/24 rates) of tax-free allowance.

  3. Lifetime Utilisation: Smart use of the NRB during one's lifetime through potentially exempt transfers (PETs) can significantly reduce taxable estates upon death.

Example: Maximising NRB and RNRB

Consider an estate valued at £900,000, including a residence worth £400,000:

  • Basic NRB: £325,000
  • RNRB: £175,000 (assuming full eligibility)
  • Total tax-free allowance: £500,000
  • Taxable estate: £400,000
  • IHT liability: £160,000 (40% of £400,000)

By using both NRB and RNRB, the estate reduces its IHT liability by £200,000 (£500,000 * 40%).

Life Insurance and Trust Structures

Life Insurance as a Funding Method

Life insurance policies can provide liquidity for IHT payments when structured properly:

  1. Writing Policies in Trust: Policies in trust are excluded from the estate, avoiding additional IHT on policy proceeds.

  2. Relevant Property Trusts: These trusts hold life insurance policies, offering distribution flexibility and potential tax benefits.

Legal Considerations for Trust-Based Plans

When using trust structures for IHT planning, consider these legal principles:

  1. The Rule Against Perpetuities: Although largely abolished by the Perpetuities and Accumulations Act 2009, this rule can affect older trusts and impact long-term planning.

  2. Settlor-Interested Trust Rules: Section 102 Finance Act 1986 prevents settlors from benefiting from certain trusts without adverse tax consequences.

  3. Reservation of Benefit: The Gift with Reservation of Benefit (GROB) rules under Section 102 Finance Act 1986 can negate the IHT benefits of gifts where the donor retains a benefit.

Case Study: Life Insurance Trust Implementation

The case of Eversden v Eversden [2013] EWCA Civ 1164 highlights the importance of proper trust documentation. The Court of Appeal ruled that life insurance proceeds were part of the deceased's estate due to improper trust setup, resulting in an unexpected IHT liability.

Asset Transformation Strategies

Generating Liquidity Through Property

Converting illiquid assets, like property, into cash is often necessary to meet IHT obligations:

  1. Equity Release: Provides funds for IHT while allowing continued residence. However, it might reduce the estate's value for beneficiaries.

  2. Sale and Leaseback Arrangements: Releases capital while ensuring continued property use, but must be carefully structured to avoid GROB issues.

Business Property Relief (BPR) and Agricultural Property Relief (APR)

These reliefs, under Sections 103-114 and 115-124C IHTA 1984, can offer major IHT savings:

  1. BPR: Offers up to 100% relief on qualifying business assets, including certain unlisted company shares.

  2. APR: Provides up to 100% relief on qualifying agricultural property, subject to specific conditions on use and occupation.

Strategic Use of Reliefs: The Balfour Case

The case of HMRC v Brander (the Balfour case) [2010] UKUT 300 (TCC) shows how combining APR and BPR can improve tax efficiency. The Upper Tribunal allowed both reliefs on different elements of a single estate, optimizing taxes.

Advanced Planning Techniques

Discretionary Trusts and Their Tax Role

Discretionary trusts offer estate planning flexibility but include complex tax elements:

  1. Entry Charges: Transfers into discretionary trusts above the NRB incur a 20% immediate IHT charge.

  2. Periodic Charges: A max 6% charge applies every ten years on the value exceeding the NRB.

  3. Exit Charges: Proportional charges apply when capital leaves the trust.

Post-Death Variations and Disclaimers

Section 142 IHTA 1984 allows post-death changes, providing tax optimisation opportunities:

  1. Deed of Variation: Can redirect bequests within two years of death, potentially using IHT exemptions more effectively.

  2. Disclaimers: Beneficiaries can disclaim inheritance, possibly resulting in assets passing to alternative beneficiaries with better tax outcomes.

Example: Optimising Tax Through Post-Death Planning

Consider an estate where £500,000 was left to a child, resulting in a £70,000 IHT liability:

  • A deed of variation redirects £325,000 to a discretionary trust for grandchildren.
  • The NRB covers this, reducing the taxable estate to £175,000.
  • New IHT liability: £70,000 - £130,000 (40% of £325,000) = -£60,000 (a £60,000 saving).

Strategic Gifting and Lifetime Transfers

Careful lifetime gifting can significantly reduce estates and lower IHT:

  1. Annual Exemptions: Individuals can gift up to £3,000 annually tax-free. Couples can combine for £6,000 total.

  2. Potentially Exempt Transfers (PETs): Gifts over the annual exemption may still be IHT-exempt if the donor survives seven years after giving.

  3. Regular Gifts Out of Income: Regular gifts that don't affect the donor's lifestyle can be IHT exempt, regardless of the seven-year rule.

Example: Lifetime Gifting Plan

A person implements a gifting strategy over ten years:

  • Annual gifts of £3,000 to each of two children (£6,000 total)
  • Additional PETs of £50,000 every three years
  • Regular monthly gifts of £1,000 from excess income

Over a decade, this could remove £190,000 from the taxable estate without incurring IHT, assuming the donor survives seven years after the last PET.

Conclusion

Understanding methods to fund initial IHT payments is key in estate administration. Through strategic planning and understanding of legal frameworks, those involved in the process can make informed decisions that benefit estates and heirs, ensuring compliance and efficiency in managing affairs.