IHT conundrum

Inheritance tax (IHT) is looking increasingly like the next stamp duty land tax: a tax that will mushroom quickly to affect many more people than initially expected.

This year's Finance Act has closed most opportunities to make a potentially exempt transfer (PET) into trust. In the main those gifts are now chargeable transfers falling within the more onerous discretionary trust regime. One interesting way round this restriction is already surfacing based on a gift into trust for a limited period and subsequently gifting the retained reversionary interest.

When announced in the Budget the changes to trusts and IHT were totally unexpected. They give rise to several questions:

- What will next year's Budget bring: will all gifts not covered by immediate IHT exemptions become chargeable transfers?

- Will the Chancellor stop or limit the ability to gift as an immediate exemption accumulated unspent income that has remained as cash?

- Will the IHT income exemption be capped?

- For how long will the perceived IHT advantages of having funds within a SSAS remain?

At a strategic level it is often a mistake to give IHT planning advice in isolation from other considerations. Indeed most clients in or approaching retirement would not place IHT as their top priority. For most clients the main concern is how to fund adequate care if their health deteriorates or when they become older. This worry is usually why many clients are reluctant to give money away to use IHT gift allowances. Discounted gift scheme may offer income back to the client but the capital has gone forever: and that is before you consider the initial and ongoing costs and investment performance. Other matters to keep in mind include '“

Health

Most advisers will ask questions about a client's health. How many advise clients to have a full medical assessment before they will give detailed advice particularly before any retirement planning discussions take place? I remember a client some years ago now who was in his late 50s with part of his retirement funds in drawdown. He had a shortfall of income over expenditure of about £15,000 p.a. His adviser had talked about bringing more funds into drawdown. The client had just recovered from a serious cancer operation and was able to obtain an annuity rate approaching 15% per annum guaranteed for five years. The drawdown funds were used to buy the annuity and that immediately resolved his shortfall in income with no equity risk. The remaining pension funds outside drawdown were kept back as a reserve in case health deteriorated further and the client needed to buy more care for himself. The death benefit remained in trust for his children.

I recall another client whose pension agency was with a major institution. The client died within a year of retiring and taking an annuity at aged 65. His comparatively modest pension fund had bought a single life annuity at standard rates that had no capital protection. The death certificate gave the primary cause of death as lung cancer. When I discussed the matter with the client's widow, I was told the client had smoked heavily for very many years. This client was probably dying when his annuity was purchased.

Contingency planning

This is often the most neglected area. Clients will plan for death with a will but do they ever ask fundamental questions such as '“

- What if I lose my driving licence?

- If my health deteriorates and I need help, do I want to be looked after at home or go into a nursing home?

- Who will manage my financial affairs and help me with my care arrangements?

- What will be the cost of care at home and how will I pay for this additional expenditure?

- Should I move nearer to other family members before I need to do so?

Attorneys

Creating an enduring power of attorney can be the equivalent of putting your head into a lion's mouth: you are totally dependent on the attorney doing what is "right". Only twice have I heard clients refuse to make an adult child an attorney because they are concerned about the child's integrity or financial ability. Nearly all clients will indicate they have total trust that their children will look after them.

Unfortunately I have met many occasions when attorneys who are potential beneficiaries will focus more on protecting their (still to come) inheritance rather than doing what is best for their principal. Whilst the principal has mental capacity the attorney must take instructions. There is always a tendency for attorneys to "bully" their principal. Even when mental capacity is being lost and an EPA has been registered, the principal will still be very much aware of what is happening '“ but unfortunately not be able to do much about it. It is often cheaper for a client to be looked after in a nursing home than to be looked after in his or her own home.

For these reasons clients need to think about whether the Court of Protection procedure should be used instead of an EPA being put in place. If that is the decision we would always supplement the Court of Protection fall-back position with an advance directive '“ a detailed statement of wishes as to a preference for a receiver and how the client wishes to be looked after and his or her money spent.

With lasting powers of attorney due soon, this will become an even more difficult and challenging area.

Asset allocation and real growth

Retirement can be for several decades. The cost of many services needed in retirement is increasing faster than the RPI. It is vital for clients to continue to have exposure to assets that will offer real growth ie growth in excess of inflation. In looking at asset allocation, it can be useful to capitalise pension and annuity income as part of the process of reaching a decision as to what to retain or invest into equities and property funds. I have always had reservations about hedge funds '“ but that is a separate debate.

Liquidity

If a client suddenly has a health problem and money is needed for a private health operation or to supplement income for care at home, where will the funds be found? Going a step further if an impaired life annuity is going to be purchased, what funds would be used for that expenditure '“ particularly if the stock-market had recently suffered a substantial fall?

Back to IHT

IHT planning can then be worked into these other considerations. It is obviously going to include:

- Is a safety net needed, some form of insurance? There is already a greater focus on whole of life policies, but do these offer good value to the client?

- If the client has the expectation of an inheritance, could an approach be made to the potential benefactor with the request that instead of an outright gift being made, a discretionary trust is created in the will with the client being merely a potential beneficiary. The ability to redirect with a deed of variation may not always be available. Properly considered wills for the whole family are obviously important.

- Even after death there are steps that can be taken that, sometimes dramatically, will reduce the tax liability. For example

+ The interaction between IHT and CGT and consideration of the various IHT valuation rules.

+ Are what are thought to be PETs immediate transfers?

+ Consideration of the loss on sale of securities relief within a year of death and the ability (still) to bed and breakfast.

+ Retaining real property in the names of the executors ("the appropriate person") in case there is a sale within four years of death at a loss (residential property prices may not always continue to rise).

+ Would any BPR or APR reliefs be available? For example if a client is an artist painting until his death, is there the possibility of BPR relief on his house/studio.

- Occasionally in family situations a proprietary estoppel argument can arise ie a position where a beneficiary has changed his or her position to the beneficiary's financial detriment on reliance on a promise made by the deceased. By their nature these arguments are best stumbled upon after death if they are to have a real prospect of reducing IHT '“ but the results can be spectacular.

These are just some of the matters that need consideration. There are others - pension planning is an obvious area. One thing that is certain is that the rules and other matters to be considered will not remain static. IHT is a classic stealth tax '“ cocooned in some complexity and easy to collect from a dead and, therefore, uncomplaining taxpayer.