Contractors keen to minimise the amount of inheritance tax they pay on their assets when they die, and maximise the value of the assets they leave to their family, should ensure they have a will and start tax planning as soon as possible.
This is according to James Abbott, owner and head of tax at contractor accountant Abbott Moore. He highlights that inheritance tax rules are complex, so seeking professional assistance from an accountant is advisable.
“Contractors who fail to plan properly risk losing 40% of their assets in inheritance tax payments to the government when they die,” he says. “Implementing a tax strategy can ensure that the maximum amount is passed on to a contractor’s loved ones.”
Get a will immediately, even if it starts as a template from the internet
Abbott warns contractors without a will that if they die ‘intestate’, then it is the state that determines what happens to their assets, and not the people they wish to leave their wealth to.
“There are laws that dictate how a contractor’s assets are distributed if they die intestate,” explains Abbott. “The contractors preferred beneficiaries, such as family, lose control over where the money goes, and the contractor’s estate may end up paying more inheritance tax than it should.”
Contractors who fail to plan properly risk losing 40% of their assets in inheritance tax payments to the government when they die
James Abbott, Abbott Moore
Will templates bought online or from a stationery shop are perfectly legal, as long as they meet minimum requirements such as being signed by two witnesses. However, Abbott urges contractors to consult a professional, such as a solicitor, who will ensure the will is properly drafted and implemented.
When a spouse inherits – maximising the use of the nil rate band
Everyone has what is called a nil rate band when they die, which is £325,000 (correct at the time of writing). This is the amount of assets they can leave without paying 40% inheritance tax to HMRC. Assets over this will have 40% inheritance tax deducted before they are paid to beneficiaries. Gifts made by the deceased are normally included in the value of the estate if they are made within the seven years before they die.
But spouses have special rules. Abbott explains: “In general when a contractor dies their assets passed on to a spouse will be free of inheritance tax, unless the spouse is not domiciled in the UK [see below]. There will be no inheritance tax, regardless of how big the contractor’s estate is.”
HMRC rules says that when the surviving spouse dies and leaves the assets to their children, the estate will benefit from both the recently departed spouse’s nil rate band of £325,000 and from the other spouse’s nil rate band. So, up to £750,000 can be left to a beneficiary without it attracting any tax.
“The ability to use both spouse’s nil rate bands automatically is relatively recent, so contractors with older wills subject to the old rules might wish to ensure that they update their will and any tax planning accordingly,” adds Abbott.
Non-domiciled spouses have different nil rate bands
The rules start to get more complicated if one of the spouses is not domiciled in the UK. Abbott explains: “If a contractor domiciled in the UK dies, and leaves their entire estate to their spouse, the spousal exemption still applies.
“However, the exemption for transfers to spouses who are non doms is capped at £55,000. So, if a contractor passes their assets to a non-dom spouse, they pay 40% inheritance tax on the assets over £55,000.”
This, says Abbott, is because inheritance tax is based on domicile status and therefore without such a cap the first spouse’s estate may escape the tax net forever.
“However, from 6 April 2013, the non-dom spouse can elect to come within the scope of UK inheritance tax and obtain similar inheritance tax exemptions as someone who has always been domiciled here, including benefiting from the nil rate bands.”
Business assets qualifying for inheritance tax
The principle of inheritance tax is that a contractor is taxed on the value of what they own when they die. Sometimes, as Abbott highlights, this can include business assets, such as a limited company: “Business assets may be exempt by the business property relief (BPR) rules. This would, for example, remove the value of a contractor’s limited company from the estate.
“There are several criteria to be met. The company must be trading. So, if the contractor has been ill for many months or years and not earning fees, then it will not be a trading company, and so would form part of their estate when they die.”
If there are outstanding director’s loans owed to the contractor by the company, these will form part of the personal estate, because they are a debt to the contractor which can be repaid. Overdrawn loan accounts reduce the value of the estate, because they are a debt that the contractor owes to the company.
“If the company has grown beyond being a simple contractor business, or there is another contractor able to take on the fee-earning role in the original contractor limited company, then the business can be passed on to a spouse or any other beneficiary. There is no tax liability and the business can continue to run as before, as a going concern,” says Abbott.
Using unlisted shares and BPR to avoid inheritance tax
Business property relief (BPR) can also be used as a tax planning tool if the contractor can find assets to invest in that qualify for the relief. This is a well used method of avoiding 40% inheritance tax.
Abbott explains: “Most unlisted shares qualify for BPR, and for the purposes of the inheritance tax rules, this means any shares not listed on the London Stock Exchange’s main market.”
Shares on AIM (formerly known as the Alternative Investment Market) are unlisted according to HMRC’s rules, so contractors can save inheritance tax by investing in AIM listed shares so long as they have been held for at least two years.
Gifts and lifetime exemptions
Abbott warns against contractors counting on the fact that they can simply give everything away on their deathbed to avoid tax: “HMRC is well ahead; to counteract a contractor giving away their estate in the final moments of their life, anything in the last seven years is included for inheritance tax valuation purposes.
“So, a contractor who gave a £100,000 gift to each of their three children three years before they died may then have £300,000 added back into their estate for the inheritance tax calculation, and the estate will have to pay 40% of that sum – a significant £120,000 in tax.”
Unfortunately, this would also prevent a terminally ill contractor from distributing their assets before they died without incurring inheritance tax.
There is what are called lifetime exemption rules. Under these rules, contractors can give away up to £3,000 a year with no tax penalty. Contractors can also give gifts out of income, if it does not reduce their standard of living.
So, a contractor with a generous pension may decide to give some cash to their children on an ongoing basis without penalty. This might also apply to giving a generous gift as a wedding present as there are other specific exemptions based on certain events.
Capital gains tax on gifts
Abbott identifies yet another trap set by the taxman: “Some assets, such as a share portfolio, will attract capital gains tax if given away as a gift.
“If a contractor gives a portfolio away to someone associated with them, it is deemed to be at market value even though the contractor received no money for it. The contractor then has to pay capital gains tax on the gain if it’s worth more at the time of the gift compared to when they first bought it.”
“It is not easy for a contractor to time everything just right so they have given away all their cash and assets except for the last £325,000 of their wealth just before they die,” says Abbott.
Trusts and powers of attorney
Often, the objective of a contractor with assets to bequeath will be to control what happens to their money after they die or become incapacitated; or to at least have some control over who actually has control. This can be facilitated by trusts, an enduring power of attorney or simply appointing co-directors.
A trust is where the beneficial owners are different from the legal owners. Abbot explains: “A trust will hold assets on behalf of an individual, or individuals. It separates who is controlling the asset from who it is benefitting, and can be a useful tax planning tool.
“It may also be used for a spouse to ensure their assets are left to their children or heirs of their choice. If, for example, a contractor with a family died, and they wanted to ensure their children benefitted from the house and assets, and the value not be diluted if the surviving spouse subsequently remarries, they could put the property into a trust. The spouse could continue living there until the children were deemed old enough to own the asset.”
An enduring power of attorney might be used if a contractor was incapable of managing their assets due to illness, or was suffering from a debilitating disease. In such cases, someone else takes legal responsibility if a contractor starts to have difficulties.
Appointing a co-director
“The spouse of a contractor who is sole director and shareholder of a contractor limited company, and the only signatory on the bank account, would have a nightmare if something happens to the contractor,” notes Abbott.
“A simple solution is to make the spouse a company office holder and signatory on the bank account. That would mean that if the contractor fell under a bus, their spouse could still manage the money.”
Abbott concludes: “Will preparation and inheritance tax planning is complex, as are the rules governing them. Mistakes are potentially very expensive, so this is definitely an area where contractors should seek expert professional assistance.”