What's Your Home Worth?

JOHN T NEWTH FCA, FTII, FIIT, ATT explains the increasing threat of inheritance tax to the small estate and offers some straightforward solutions.

RECENT PRESS REPORTS have highlighted the fact that more and more relatively small estates are threatened by the imposition of inheritance tax. While one welcomes the increase in the inheritance tax exemption to £250,000 in the 2002 Budget, this means very little to people living in the South East.

A three-bedroomed semi-detached house in the London area is likely to be worth more than the exemption figure and the estates of many of those who would regard themselves as not well-off could well come under the Chancellor's knife.

The need to plan

So what can be done to assist those with small estates? It is well known that, certainly in the past, inheritance tax has been 'a voluntary tax' for large estates, who have the help of sophisticated planning techniques.

However, there is a vast market 'out there' in relation to the small client and it is therefore necessary for every tax practitioner to have a basic grasp of estate planning principles, unless he or she wishes to subcontract every case to a specialist and lose potential fees. The success of the Society of Trust and Estate Practitioners illustrates all too clearly the need for specialist advice.

Having said that, those with modest estates may not be able to afford the fees likely to be charged by specialist firms; this is why the average tax practitioner needs to be aware of what can be done in such circumstances.

The will

Before considering some basic ideas, one has to mention the proviso to all estate planning, and this is particularly relevant to today's family life. The proviso is that gifting of assets to one's spouse or partner or to the next generation should generally be regarded as irrevocable, except in the context of certain sophisticated schemes.

Tax practitioners therefore need to bear in mind the changing pattern of family relationships when advising clients in this area. Marriage is on the decline and in many instances there is a 'partner' instead of a spouse. It should be recognised that a partner has no rights under existing intestacy law. There are also many single parent families and one has to accept that some traditional family arrangements will end in divorce. All this highlights a necessity for good professional indemnity insurance before embarking on estate planning advice.

The most basic question of all to a client is 'have you made a will?'. Has your wife, husband or partner and other family members made wills? It is amazing how many individuals, for whatever reason, have not made wills. They include members of the tax profession.

Intestacy

Lack of a will will invoke the intestacy rules, leaving the surviving spouse perhaps to cope with less provision than he or she expected or the deceased intended. Since 1993, on an intestacy where the surviving spouse has children, the surviving spouse only receives the personal chattels and £125,000 absolutely. He or she then receives a life interest in one-half of the residue, with the children receiving a life interest in the other one-half of the residue.

While an intestacy, as for a will, can be varied for inheritance tax purposes, this is not always straightforward, particularly where minor children survive the deceased.

It is worth considering the family difficulties that such a scenario might produce. The distribution of the estate may be quite the opposite of what the deceased intended. Matters are made even worse where the deceased has a partner to whom he or she was not married, but regarded as a spouse. Such a partner would receive nothing from the estate under intestacy, leaving him or her to take legal action for provision as a dependant of the deceased.

If there is a will, is it up to date? Wealth and family relationships change and a will needs, at the very least, to be reviewed every five to ten years.

Protecting the estate

Many husbands and wives with small estates are constrained from making estate planning moves because of the need to preserve the family home and to make sure that the surviving spouse has sufficient free capital and income. It is perverse that the opportunities for inheritance tax saving are much more readily available to those with larger estates.

However, some things can be done, but with the definite proviso that they will need the trust, co-operation and integrity of all family members.

The home

Let us consider again the Example and the estate of Mrs Brown. It is assumed that the home had been owned jointly as joint tenants by the late Mr Brown and his wife, and that it passed to Mrs Brown automatically on the death of her husband. However, suppose that during his lifetime the joint tenancy had been severed and in his will Mr Brown left his 50 per cent share to the three children. There is no gift with reservation of benefit in this situation, since the donor is deceased, but the three children would be responsible for the upkeep of their half-share of the property.

However, for inheritance tax purposes the outcome would be that on Mrs Brown's death, her estate would total £130,000 from the home and £30,000 other capital. £160,000 is well within the inheritance tax exemption and tax of £16,000 would be saved.

One must stress that this type of scheme requires the co-operation and trust of all the family members and the administration of it must proceed correctly. In fact, in this instance, Mr Brown could have gifted a lesser sum than 50 per cent of the property to the next generation in order for the inheritance tax to be saved.

The arrangement can even be put into effect posthumously by means of a deed of variation of a will. Contrary to popular perceptions, it is possible to declare in a deed of variation that the joint tenancy be severed and the deceased's share in the home can thus be diverted away from the surviving spouse.

Some prefer to leave the share in the home on discretionary trusts, and here a major question is whether the surviving spouse requires an interest in possession in the share held in the trust. The final outcome of the appeal in Commissioners of Inland Revenue v Eversden [2002] STC 1109 may resolve this question.

It is beyond the scope of this article to consider this in detail, but one has to consider the possibility that at some time Mrs Brown might have to go into a state or private nursing or rest home. Single personal ownership of her home could make her vulnerable to a move by the local authority to force her to dispose of her home in order to fund nursing home fees. It could be that, had Mr Brown left the half-share to the children, this would in effect preserve the estate for the next generation.

Cashing in on the home

In the case of Mrs Brown, one has assumed that her income is sufficient and that she does not need to draw on capital in order to supplement her living expenses. However, in many instances retired people are living in properties with a substantial or even inflated value but with an insufficiency of income.

I almost hesitate to suggest the following course of action because of the past scandals and possible current ones concerning home income plans. However, I understand that there is now an industry association, SHIP (sale home income plans). Various schemes are available, including the equity release scheme, where a percentage of the value of the home can be advanced by sale to the lender at a discount.

If a home income plan were taken out, there are various ways in which the capital raised could be used.

Funding life assurance

In our Example, suppose that Mrs Brown raised £50,000 on her home. She might use £40,000 of this to purchase an annuity. Provided she was in good enough health to obtain good medical terms, she could then use the income element of the annuity to take out life assurance written in favour of the next generation in trust either under the Married Women's Property Act or other type of trust policy. The annuity and life policy must not be 'associated operations' and it is preferable that they are taken out with different insurance companies. Full medical disclosure would be required in the case of the life policy.

The result of a successful arrangement of this type would be that £40,000 is removed from the estate by the purchase of the annuity, saving the whole of the potential inheritance tax. The estate would then have a net reduction of £24,000, compared with current calculations, but the beneficiaries would benefit from the value of the life policy. Whether this scheme would result in an overall gain would depend on the figures and such an arrangement may or may not be worth undertaking.

Funding gifts

Alternatively, Mrs Brown, if she had no income worries, could use the full £50,000 gained from an equity release scheme to gift money to the next generation. The gifts made would be potentially exempt transfers, except perhaps to the extent of £6,000, being two years' annual exemptions. The beneficiaries would receive part of their inheritance early, but the success of the arrangement would depend on how long Mrs Brown lived.

The beneficiaries could then take out a seven-year term assurance on Mrs Brown's life in order to fund any potential inheritance tax if the potentially exempt transfers became chargeable.

Other insurance arrangements

Other insurance arrangements are available, quite apart from home income plans. For instance, if Mrs Brown's income was sufficient, it might be possible for her to take out a life policy in favour of the three children paid out of 'normal income'. This will be much more preferable than disturbance to the ownership of the home or purchase of an annuity and could produce better overall savings.

In hindsight, during the lifetime of Mr Brown, it might have been possible for he and his wife to take out a joint life and survivor whole life or endowment policy in favour of the children, once again written in trust. The sum assured would be for a figure equivalent to the inheritance tax estimated to be payable on the estate of the survivor.

The problem with this type of policy could be the lack of necessary funds to pay the annual premium, although one has to say that both husband and wife are able to use the £3,000 annual exemption for gifts made out of capital for this purpose. It should be borne in mind that in every case every use of the £3,000 annual exemption for gifts by husband and wife saves a potential £1,200 in inheritance tax.

In the current circumstances, Mrs Brown could use some of her other assets of £30,000 to make annual gifts of £3,000 either directly in cash or as premiums on the life policy written in trust. In the case of the latter, this is on the basis that she cannot afford to pay the premiums out of income.

Finally, another variation could be for the three beneficiaries of Mrs Brown's will to pay premiums on a policy written on her life in order to meet the anticipated inheritance tax liability. They will be receiving the benefit of the estate and have to gamble on the size of the premium compared with the saving of inheritance tax of £16,000 or more. The persons who pay the premiums must have an insurable interest in the policy for such a life of another arrangement to be effective.

Conclusion

This is a brief consideration of what can be a very complicated subject. Many other manoeuvres available to more wealthy taxpayers have not been mentioned, such as discretionary trusts and the gift by the first spouse to die of a sum equivalent to the inheritance tax exemption figure of £250,000 to the next generation.

The fact is that one cannot give funds away and still benefit from the capital or income. At the same time, the Treasury wants its slice of capital over a certain figure. It is a political issue as to whether the exemption limit of £250,000 and an immediate tax rate of 40 per cent on the excess is fair or reasonable, but for the time being we have to accept life as it is.

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