How do the very rich avoid inheritance tax?
Our guide to IHT-avoidance measures used by the mega-wealthy.Tue, 27 Oct 2020 Author: Rowena Kelly
There is a popular perception that inheritance tax (IHT) is almost optional for the very wealthy. This is not the case, but it’s easy to see it this way in light of the loopholes and avoidance techniques the super-rich use to significantly reduce their liability. So what are these mysterious IHT-avoidance methods and are they the reserve of the mega-wealthy? Here’s our guide.
The super-rich and inheritance tax
Inheritance tax is not a popular tax. In 2015, a YouGov poll found that 59% of people questioned said it was an ‘unfair’ tax compared with 22% who said it was fair. This is despite the fact that only 5% of estates each year are actually affected by IHT.
From the 2021/2022 tax year, it is possible for a married couple, or couple in a civil partnership, to pass on up to £1 million in inheritance without paying inheritance tax. Therefore, IHT is only really of concern to the relatively wealthy. However, it is precisely these relatively wealthy people that pay the lion’s share of the IHT collected by the government each year.
HMRC statistics show that those with estates worth between £2 million and £3 million paid an average of 20% inheritance tax in 2015-2016. Over the same year, those with estates worth in excess of £10 million paid an average of just 10%.
Then there are the cases of the mega-rich managing to avoid IHT completely. For example, when the sixth Duke of Westminster died a few years back, he handed on £8.3 billion in inheritance to his heir, without paying IHT. How did he do it? Through a trust.
Trusts hold assets for a trustee before they are passed onto a beneficiary. They are simply a legal arrangement that allows trustees (the asset’s owners) to place their money, investments or property with a third party. The assets are then passed to the trust’s beneficiary at a later date.
How do the rich use trusts to reduce their inheritance tax bills?
Once assets are held in a trust, they no longer belong to the trustee, they belong to the trust. Therefore, these assets are not liable for inheritance tax when the trustee dies. Trusts can also be used as a way to ‘look after’ assets for a beneficiary until they come of age or meet other pre-specified criteria.
The list of beneficiaries could be very long, and, in theory, the assets held in the trust could be distributed to any or all of these beneficiaries. This, again, means the assets don’t ‘belong’ to any specific beneficiary, further protecting the assets from the taxman.
Trusts are subject to certain taxes, however, including the Inheritance Tax Periodic Charge, which is payable every ten years following the creation of the trust. Although this charge is 6%, loopholes are used to avoid these charges, usually taking the form of a relief put in place to protect certain industries, such as agriculture. The Duke of Westminster’s trusts, for example, fully exploited the business property and agricultural exemptions that apply.
Anyone can set up a trust
Setting up a trust through a solicitor can be relatively simple and cost as little as around £1,000. However, getting advice from a professional IFA or wealth manager could help you find the most tax-efficient solution for you. There are different kinds of trusts, and assets held within the same trust can be treated differently depending on whether the trustee retains discretionary use of those assets, for example.
When you set up a trust, as the trustee, you are able to stipulate and precise terms for each asset and the wealthy do this very carefully in order to minimise the impact of IHT.
The seven year rule and ‘Potentially Exempt Transfers’
Trusts aren’t the only way the super-rich protect their estates from inheritance tax. They also start planning well in advance of their old-age in order to take advantage of the ‘seven year rule’
We talk about this loophole and how it applies in our general guide to inheritance tax, but let’s look more closely at how the very wealthy take advantage of this rule to pass millions to their heirs without paying a penny of IHT.
How is the seven year rule used by the wealthy?
Under current inheritance tax rules, each of us has an annual tax-free gift allowance of up to £3,000. Individuals can also give one-off gifts tax-free on certain occasions, such as marriage, and you can also gift money to your dependants.
If you decide to give gifts above and beyond your personal allowance, this becomes a ‘Potentially Exempt Transfer’. Quite simply, if you survive for seven years or more following the date the gift is given, the money is no longer taxable under IHT rules. In fact, the rate of IHT, which is set at 40%, starts to reduce as soon as you’ve survived for three years, falling on a sliding scale until you reach seven years.
This is why the very wealthy begin their estate planning long before they reach their twilight years. Some will be giving gifts to their beneficiaries tax-free decades before their death.
Most of us are aware of the importance of life insurance to protecting our families in the event of our death. But many of us are unaware that it is possible to take out a life insurance policy that will pay the inheritance tax on your estate when you die.
How do the super-rich use life insurance in their estate planning?
Wealthy individuals who have taken advice from tax lawyers and wealth managers will often opt to take out a whole-of-life assurance policy, which will pay out a guaranteed lump sum when the policyholder dies. The policyholder can work with their adviser to ensure that the amount the policy beneficiary receives is enough to cover the inheritance tax bill on the deceased’s estate.
Whole-of-life assurance policies should only be considered after a thorough cost/benefit analysis has taken place, as premiums don’t come cheap. However, life insurance policies are not considered by HMRC to be part of a person’s estate, so they can offer a tax-efficient way to meet the costs of IHT at the point of death in certain circumstances.
The problem with inheritance tax, as it stands
Campaigners, such as the Resolution Foundation, have been pushing hard for the current inheritance tax to be replaced with a different, fairer, more effective tax (the Lifetime Receipts Tax), which performs better for the state. It claims that only 0.77p for every £100 in tax collected comes from inheritance tax. The Foundation suggests that beneficiaries should be taxed individually on what they receive in inheritance above and beyond a personal allowance.
The Foundation is also calling for tightening of the Business Property Relief and Agricultural Relief, which are thought to have cost the government £1.2bn in lost inheritance tax on trusts.
The ‘just wealthy’ are feeling the pinch the most
One of the reasons that the tax has such a bad reputation is that the wealthy are paying far more in IHT than the very wealthy. However, this is simply down to the general unwillingness to plan. A 2016 Canada Life survey found that only 26% of the wealthy people they questioned had sought professional estate planning advice.
The survey found that the estate planning techniques discussed above, frequently used by the UK’s richest people, are being actively rejected by those who are ‘just wealthy.’ Some 47% of those questioned said they had ‘no intentions’ of taking out life insurance as part of their tax planning and 40% said the same of setting up a trust. It’s no great surprise, then, that those with estates worth £2-£3million bear the brunt of the IHT bill each year.
So what’s holding the wealthy back?
There are several reasons why so few wealthy people contemplate estate planning in the same way the very wealthy do. One reason is that they expect estate planning to be complicated and time consuming, which isn’t the case. Another is that they have never obtained financial advice and are therefore simply ignorant to the options available to them.
Canada Life’s head of technical services, Karen Stacey, explained: “Even options seen as complicated, such as setting up a trust, can be very simple when consumers know who they want to benefit from their estate and get advice from a professional on how to achieve their objectives.”
However, there is one final way to avoid paying IHT, which is to spend all your money while you’re still alive! It seems that a growing number of people who fall into the ‘wealthy’ bracket are simply too concerned about running out of money in their old age. They are unwilling to give large cash gifts to their children, which they may need themselves in retirement. Around 20% of millionaires aged over 45 said they plan to spend their wealth before they die, passing nothing at all onto their heirs. This is expected to create a new generation of ‘heirs-but-not-beneficiaries’, who may be in even greater need of financial guidance and advice than their parents.