Deathbed Tax Planning
Capital Gains Tax versus Inheritance Tax
IT IS said that there are only two certainties in life: death and taxes. However, there is some comfort in the fact that one of these certainties can sometimes be used to reduce the impact of the other - with careful inheritance tax planning.
Sadly, this does not mean that paying more tax will make you live longer (although the Government might try to convince you otherwise), but what it does mean is that death can sometimes be used as an opportunity to save tax.
When we think of death and taxes, we usually think of Inheritance Tax: and rightly so – because that evil grave robbers tax is indeed a major problem for many bereaved families.
But, as far as Capital Gains Tax (CGT) is concerned, death can actually provide the means to save tax.
Why Is This?
When assets pass to another person on death, they may or may not be subject to Inheritance Tax but they are generally exempt from CGT. Furthermore, not only are they exempt, but the new owner is treated as if they had acquired the asset at its market value at the date of death. This is what we call the CGT uplift on death and, under the right circumstances, it can provide a major tax-saving opportunity.
What are the ‘right circumstances’? Well, the best tax-saving opportunities arise when a member of a married couple or civil partnership dies holding assets such as investment property or stock market investments. These assets will generally attract CGT at 28% on a sale or lifetime transfer, or Inheritance Tax at 40% on death, but can usually be passed to a surviving spouse free of both taxes.
Tony and Janet are a married couple and joint owners of a portfolio of investment properties worth £1m. The properties were purchased many years ago for a total of £200,000.
Ideally, the couple would like to pass the properties to their daughter Jamie but this would give rise to CGT of £224,000. They have looked into using a trust to pass some of the properties to Jamie but this would only work for the first £650,000 worth of property (without giving rise to an immediate Inheritance Tax charge) and, even then, both of the couple would need to survive for at least seven years.
They decided against the trust route due to concerns over Tony’s health and, indeed, a little while later, his health deteriorates further and his doctors advise that he has only a short time left to live.
Tragic as this is, the family seize their opportunity and Janet transfers her share of the investment properties to Tony before he dies. These transfers are exempt from CGT because they are between spouses.
On his death, Tony leaves everything to Janet, so there is no Inheritance Tax because all the transfers benefit from the spouse exemption.
Janet is now treated for CGT purposes as if she had purchased the properties for their current market value of £1m. She can now either sell them or transfer them to Jamie but, either way, she should have no CGT to pay.
If Janet does transfer the properties to Jamie, and survives for at least seven years thereafter, there should be no Inheritance Tax on them either. In fact, some savings would begin to accrue even after just three years.
The interesting thing about this planning is that it is rather counter-intuitive. We are all used to the idea of divesting ourselves of assets as we get older in order to reduce our family’s Inheritance Tax bill. But, as we can see from the example, this family saved £224,000 by transferring assets to a dying parent.
Now that we have the transferable nil rate band for Inheritance Tax purposes, most families will have nothing to lose by using this planning method – and everything to gain!
There are a few exceptions, however. Where one or both of the couple is already a widow or widower (or surviving civil partner) from a previous marriage, there can be more benefit in transferring some assets directly to a child or other beneficiary on death. The tax-free uplift for CGT still applies, however, so transferring assets to the dying spouse before death will usually still yield savings.
Some care needs to be taken where the family is seeking to pass assets to the next generation quite soon after the first parent’s death. Where there is any type of request, no matter how informal, asking the beneficiary under a Will to transfer inherited property to another person and the beneficiary does indeed make the requested transfer within two years of the deceased’s death, the transfer is treated as a direct transfer from the deceased to that other person.
In our example above, this would mean that Inheritance Tax was payable on the properties which Tony left to Janet. It is all too easy to trigger this provision. Even if the dying Tony simply said to Janet “you will look after Jamie, won’t you”, HMRC might construe this as an informal request and apply the provision (I have no idea how they sleep at night!)
In short, what happens after the first spouse’s death has to be left entirely in the hands of the survivor. If in any doubt, the survivor could avoid the risk posed by this provision by waiting two years and a day after the deceased’s death before passing the assets on to the ultimate recipient. There are two potential drawbacks to this, however.
Firstly, the second spouse would then need to outlive the first by at least nine years for the properties to pass completely free of Inheritance Tax. Even so, there will be cases where the survivor’s life expectancy is long enough to mean that this is not a massive concern and this risk can also be covered through term assurance.
Secondly, the widow or widower would be exposed to CGT on any growth in the value of the properties between the date of the deceased’s death and the date of the transfer to the ultimate recipient. This may mean that the properties cannot be passed on totally tax-free but 28% on two years’ growth is certainly a lot better than 40% on the entire value!
In most cases, however, the most difficult thing about this planning may be the fact that the action required has to be carried out at a very stressful and emotional time. Nevertheless, if the Government is hard-hearted enough to use death as an opportunity to raise taxes, why shouldn’t we use it as an opportunity to save them?
Pitfalls to Watch Out For
This type of planning will work well for some families but there are a few things to watch out for.
Firstly, where the surviving spouse is non-UK domiciled for Inheritance Tax purposes, the spouse exemption for Inheritance Tax is capped at just £55,000, so this planning may not work as intended.
Remember also that the spouse exemptions for both CGT and Inheritance Tax apply to legally married couples and registered civil partners only. Furthermore, the CGT exemption for transfers between spouses does not apply where the couple have separated before the beginning of the tax year in which the transfer takes place.
Any mortgages or other borrowings over the properties transferred can lead to Stamp Duty Land Tax liabilities, or even mean that the transfers cannot take place (we all know how co-operative banks are these days!)
But, most of all, the survivor needs to be sure that the transferred properties will indeed come back to them when their spouse dies. There cannot be any arrangement which guarantees this or the planning would not work: it has to be left to the dying spouse’s Will.
So, before undertaking this inheritance tax planning, the healthy spouse should ask themselves whether there is any risk that the dying spouse might leave the properties to some mysterious third party, or even just to the local cat and dog home. These things do happen and, whilst the law provides some protection to bereaved dependents, it will seldom extend to investment properties!