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How to avoid UK inheritance tax

You are a 70-year-old with £5m of investments which you want your children to inherit. But you’d like to avoid the £2m of inheritance tax.

You ask your tax adviser for advice on how to avoid the tax, and are expecting a long complicated memo, proposing a tax avoidance scheme involving seventeen companies, three tax havens, two trusts, and large fees.

What you actually get is written on a postcard:

  • Step 1: Sell your existing investments1Won’t there be CGT on the sale? Probably not much. £1m of the investments are in an ISA. As for the rest, like any tax-obsessed investor, you’ve been managing CGT as you go, crystallising gains to use your annual allowance, and using your wife’s annual allowance (i.e. total gain sheltered = £25k * years invested). You’ll have a bit of gain, but it’s a price worth paying. and replace them with shares listed on the Alternative Investment Market. Either assembling a diversified selection yourself, or paying someone else to do it.
  • Step 2: Make sure to live at least two years.
  • Step 3: Drop dead, happy in the knowledge you’ve avoided inheritance tax.
  • There is no Step 4.

Why does this work?

Most AIM shares qualify for complete exemption from inheritance tax after two years.

Given AIM companies are small/mid-cap, the obvious downside is that your portfolio suddenly becomes more volatile (although not as much as you might think). But many people would see that as a small price to pay for avoiding a 40% tax hit.

Why is it so stupidly easy to avoid IHT?

The road to tax hell is paved with good intentions (and also flapjack).

Inheritance tax can be unfair for small family businesses. Imagine a small shop, making a profit of £50,000/year. That business is plausibly worth £500k. So when the owners die, their children – who expect to inherit the business – have a £200k bill. A larger business could deal with this by borrowing, or bringing in outside investors – but for a small business that’s much more difficult.

So most countries with inheritance/estate taxes have exemptions for private businesses.

The UK does that with business property relief. But BPR goes much further than it needs to:

  • First, the exemption has no limit. What makes sense for the cornershop doesn’t really make sense for a £1bn business – but the exemption covers it just the same.
  • Second, the exemption doesn’t apply to shares in listed/quoted companies, for the very good reason that you can easily fund the tax by selling the shares in the market. But shares in alternative markets like AIM aren’t considered “quoted” for this purpose, even though you can easily fund the tax in precisely the same way.
Inheritance tax is just full of this sort of thing, which is why it’s so broken – see my previous blog.

How to fix it

That’s easy. Exemptions and reliefs should do what they’re supposed to do, and no more. If we are trying to protect small private businesses then business property relief should only cover small private businesses. Cap the relief at a generous but sensible level (£1m?). Exclude all forms of listed security2probably with the £1m capped relief still available to the original owner of the business, before it was listed, if they continue to hold the listed shares. Job done.

Given the high cost of BPR, this could raise a serious amount of money, and could fund a reduction in what is (by international standards) quite a high tax rate3We can ballpark this: HMRC stats show the exemption costs £1bn, and on average it’s applying to £780k of property. So we’d save c£500m if the exemption was capped at £1m. That would fund a 2% cut in the rate. And that’s just the start..

And by reducing both the rate of IHT, and the perception the rich don’t pay it, we might make the tax less unpopular, and therefore preserve its long term future.

Caveats

None of this is legal advice. Anyone stupid enough to plan their tax affairs on this basis deserves everything they get. Anyone wanting impartial and clear advice on how to avoid inheritance tax should go to this well respected independent adviser.

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5 thoughts on “How to avoid UK inheritance tax”

  1. yes – a nicely diversified tax avoidance portfolio must be the prudent choice here! But that then comes close to actually useful advice someone might follow!

  2. Jon Golding 19 May 2022

    Nice one Dan! My card would be a bit longer – sell everything and invest into forestry/agriculture in UK or EEA, AIM shares, business anywhere, making sure that any gifted items that may be taxable attract instalment option to the donee.

  3. I have no issue with your comments on AIM shares point but am not convinced otherwise.

    For example, what about a lawyer working for a law firm? The partner makes £1 million per year and, partly because of all the long hours she works, dies before being able to retire. Using your illustrative 10x multiple, her share of the firm would be worth £10m (and as luck would have it, that’s the value that a PE firm would be willing to pay to own a chunk of that firm). So should her estate have to pay £4m of IHT (or £3.6m with a £1m exemption)? While I quite like the idea of lawyers paying lots of tax, that doesn’t seem quite right when the firm is naked-in, naked-out. And that’s a phrase that I don’t want to use too often when I think about the lawyers I know.

    Or what about a company that makes £1m per year. The founder has 90% of the company with the other 20 or so employees owning 10%. The founder is the driving force behind the business and has all the great client relationships (and has a lot of personal debt because they have a big mortgage on their house and a big yacht, several nice cars and well, you know). Using your 10x multiple for convenience, the company is worth £10m for IHT purposes. But that’s with the founder still being alive. Without the founder, well the business is not worth that much. It will be loss making for a year or so and then, hopefully, gradually start to make money. If employees are to be retained, there will need to be some sort of share incentive plan as there won’t be enough to pay them what they deserve for a long while. So let’s pretend that it is worth £1m without the founder. Should the IHT really be based on 90% of £10m (lets ignore the discount to the £10m reflect that there is a minority). How will the Founder’s estate pay £3.6m of IHT when there are relatively few other (net) assets and, commercially, the shares are worth a lot less? An effective 100%+ IHT rate seems a tadge high.

    One way around that last situation would be for the founder to give some (at least half) or all of their shares to an EBT immediately prior to death to allow employees to be incentivised in the medium term. That way, there would be no IHT on those shares but is that fair to the public at large? What happens if the founder’s children have to incentivise the employees by giving them shares in the months and years after death? Is it fair that IHT had to be paid (on an artificially high value) on the founder’s death, on the shares that were shortly after given to employees (especially as it wouldn’t have been paid with a bit of pre-death EBT planning)?

    • The lawyer won’t/can’t pass the interest in the law firm to her kids, so there’s no IHT consequence at all.

      IHT is only relevant if the business forms part of the estate and is inherited, and it only applies to the market value of the business at that time. The family-run-shop example is a real one, because such a business typically is inherited, it’s easy to value, and the valuation is unlikely to be affected by the founder dying.

      • Taking your points:

        1. I shouldn’t have limited myself to just to law firms but made a wider point in relation to trading partnerships. And I should have been more specific about my concerns. The issue I have is that (i) the “goodwill” element of the deceased partner’s partnership interest often cannot be realised, and (ii) trying to do so can be sub-optimal for the economy in general. I’ve written more on this below but basically, I’m not sure that abolishing BR is the right thing to do here. To me, remove the step-up in CGT base cost on death would seem to make more sense that abolishing BR.

        2. I agree the value of a shop is unlikely to reduce as a result of the death of an individual. But there are many businesses where this is not the case. This would need to be addressed if BR is abolished. My other point was that if BR was abolished and the death of an individual was likely to cause the commercial value to the estate to be substantially lower than the tax value (s4 and s160) then people might try to take sub-optimal steps (like giving shares to an EBT) to avoid IHT.

        In my mind, I see two types of partnership interests:

        a. Capital and current accounts: These are virtually always paid out following death. I don’t see that abolishing BR is a particular issue. They are easily valued and can typically be paid out relatively quickly. Providing that the tax system recognises that the cash can’t always be realised by the normal IHT payment date, I don’t see that abolishing BR would negatively impact the economy.

        b. Other partnership interest: While many law firms don’t allow the residual ownership interest in the firm to be transferred on death, many other firms do (ranging from smaller law firms to multi-billion asset managers). These partnership interests represent value that is not shown in the accounts (e.g. goodwill) and its value is often substantial. However, it is very difficult (or impossible) to realise value from it. Therefore, there is going to be (i) real difficulty for the estate in paying the IHT on these interests if BR is abolished, and (ii) and some of the steps taken to do so, or to mitigate the risk of havin to do so, might negatively impact the economy.

        What do I mean by negatively impact the economy?

        – There may be a conflict between ongoing partners and the estate as to how to realise value. This might take a lot of time and angst (and professional fees), meaning that the owners of the business spend more time discussing and arguing about internal things rather than developing the business.

        – Some businesses will have be closed to allow value to be realised by the estate (e.g. resulting in the loss of jobs). Extending post-mortem relief would be important if BR is abolished.

        – Some businesses will be sold or split up to allow the estate to realise value before it is optimum to do so. This might lead to lower employment and growth.

        – Some partners (e.g. if in bad health) will decide to sell or close their business early to avoid complexity on death and perhaps invest in assets that are more IHT efficient (e.g. where AR is available). Again, this might result in less employment / less growth for the economy.

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