Not sure how Inheritance Tax works after death? Tax expert Michael Steed MAAT is back to guide you through the process with this second post on the controversial tax
In my last article on AAT Comment, I looked at lifetime giving and getting the maximum tax efficiency out of an estate before death.
This is vital. Remember we are trying to balance having enough income and capital for your retirement with managing the Inheritance Tax (IHT) bill on your assets on death. For example, personally I will be trying to die as near to penniless as I can, because I intend to give as much as I can in life to my children.
What we are trying to achieve here is an understanding of what happens on death and how the IHT provisions work. It’s not just IHT – it’s also dealing with probate, although I won’t be considering that in this post.
How Inheritance Tax works after death
The post-death process in England and Wales for someone with a valid will is broadly as follows:
- Value the estate (see below).
- Complete the probate application and IHT forms. The forms will vary depending on whether or not the estate owes IHT.
- Send the forms to the probate registry and HMRC and pay whatever IHT is due (this is due within six months of the end of the month of death).
- Pay any debts owed by the estate and then distribute the estate.
Valuing an estate post-death
One of the key steps in dealing with IHT is valuing the assets in the estate. Assets that typically make up a death estate include a number of items such as money in the bank or houses and land. More information on which assets can be used is available on the GOV.UK website.
The basic valuation rule is to use market value on all assets. There are special rules for shares (the quarter-up rule), and foreign property gets a 5% reduction in value to allow for overseas costs on the death.
Pensions that pay a lump sum on death will be included, but these are often paid ‘under trust’, which means they will be paid outside the estate and will not be included in the valuation.
One of the baffling facts about IHT is that trust property in which the deceased had an interest is included in their death estate.
For example, suppose the husband of a second marriage dies and wants to let his second wife live in the house during her lifetime, but wants the children of his first marriage to get the property on her eventual death.
It’s standard practice for him to leave the house in an interest in possession trust (also known as an immediate post-death interest trust) stating that she has the absolute right to stay in the house until her death, at which point the house is given to the children. She is known as the life tenant and the children are known as the remaindermen. She gets the ‘income’ and they get the ‘capital’.
The immediate point for IHT is that the value of the house is put into her estate even though she doesn’t own it. This determines the tax rate payable on her estate and the amount of IHT due to HMRC. The good news is that she (or rather her estate) doesn’t pay the tax on the house.
The IHT is paid by the trust and that means the tax may be paid by selling the house, allowing the remainder to be distributed to the children.
If the deceased has assets that are jointly owned by a spouse or civil partner, special valuation rules apply. These are the ‘related property’ rules, and individual shares in those assets are valued as a proportion of the joint holding.
Gifts and Inheritance Tax
Lifetime gifts within the seven years before death will also need valuing (I covered this in my first post), including assets that the deceased gave away at any time, but in which they kept an interest. This would include, for example, a house they gave away but lived in rent-free (this is known as a gift with reservation of benefit).
When to pay Inheritance Tax
IHT is normally due within six months of the end of the month of death, but in certain circumstances IHT may be paid in 10 annual instalments. Only some assets qualify for this, including land and property, partnership shares and certain other shares.
Sometimes the instalments are interest-free (for example the IHT due on shares in a trading company) and sometimes they attract interest (for example a house).
Needless to say, it is vital to have a valid up-to-date will. These need to be reviewed every few years. Simple will planning such as transferring all of an estate to a spouse on death, often works well, but more complicated estates will need more complex wills, including the use of trusts.
This is part two of a two-part post on Inheritance Tax. Michael’s first post looked at how IHT works and how to legally manage your finances to avoid paying it.
Michael Steed is co-chairman of the ATT's tax Technical Steering Group and columnist for Accounting Technician magazine.