Making sure that any money given to family members is passed on in a tax-efficient way is crucial, writes Mark Pattenden.
With millennials finding the cost of living increasingly difficult to manage, many parents and grandparents are choosing to advance money to the younger generation at an earlier stage in life.
However, this type of support often comes with an unexpected tax bill. Using wealth to fund education or university fees, or helping children on to the property ladder, can be subject to Inheritance Tax (IHT). It is therefore essential to plan in advance and ensure that each transaction is tax-efficient before making any gifts.
As it stands, an individual’s IHT nil rate band, i.e. the amount allowed before IHT is applied, is set at £325,000. Yet, with rising property prices and growing wealth, people in the UK have become increasingly liable for IHT, with HMRC data showing that in the 2018/19 tax year the Treasury’s receipts for IHT were nearly double that of 2008/09, at £5.36 billion.
Gifting assets during one’s lifetime is an efficient way to reduce an IHT liability. However, this has come under scrutiny recently and the Office of Tax Simplification (OTS) published a report earlier this year that recommended changes to simplify the system, including reducing the period before death in which gifts are taxed from seven to five years.
While the IHT system may well face a shake up in the coming years, it is key that people understand how they can best utilise the current legislation when looking to transfer wealth to their children or grandchildren.
Staying in control
When passing wealth to children, one of the key considerations for parents is control. Is the individual old enough and responsible enough to own the asset outright, or would some form of control of the ownership be preferential?
An outright gift means giving away control over the asset completely, whether it is cash, a share portfolio or a property. This is where trusts come into play.
Trusts can be used to provide income as and when it is needed to pay for school fees, university tuition or living expenses, without giving the beneficiary the responsibility of having to manage the asset themselves.
Using a trust enables parents to maintain control of an asset but still benefit the individual receiving the wealth. Plus, although trusts pay income tax up to 45%, when the income is distributed to a beneficiary, the tax can be reclaimed by using that individual’s own tax-free personal allowance.
Asset or cash?
Different types of gift vary in their tax treatment, so having knowledge of this is crucial.
Cash gifts direct to individuals are classed as Potentially Exempt Transfers (PETs). They do not have any immediate tax liabilities and if the donor survives seven years from the gift it will be exempt from IHT.
In addition, those in a position where they have more income than they need each year can give this surplus away without paying IHT at all. This will not be treated as a PET, as long as the gift forms part of a regular pattern, the income comes from surplus annual income and the donor is able to maintain their normal standard of living.
A gift into a trust will be tax exempt if it is below the IHT threshold of £325,000 (which could be doubled with joint settlors of the trust), but transfers over this could be subject to a 20% lifetime IHT charge.
Also important to note is that transferring property or shares into a trust could attract capital gains tax as well, if a capital gain already exists on the asset being transferred. This liability would effectively be held over and transferred to the trust, so that it would eventually pay the tax when the asset is sold.
Importantly, any capital gain on assets gifted to close family members, such as a house or painting, are deemed to take place at market value even if no proceeds are received by the donor.
This can give rise to a tax liability even without any proceeds from which to pay the tax, which then require the donor to find other available resources to fund the tax due.
Skipping a generation
As grandparents aren’t caught by the parental settlement rules, they have greater freedom than parents to give money to the younger generation. Parent settlement rules mean that parents will be personally liable if the income produced by an asset given to children under 18 years of age exceeds £100.
However, grandparents can give income-producing assets, such as a share portfolio, directly to their grandchildren without being taxed on the resulting income.
Therefore, skipping a generation in IHT planning to give assets to grandchildren (either directly or through a trust) can be extremely advantageous, particularly if the parents already have a valuable estate of their own.
Mark Pattenden is a partner at haysmacintyre.