Monday, 4th March 2019 09:42 - by Ranjeet Singh
The first thing that I wish to make clear is that this article, report, blog, call it what you will, is not investment or tax advice. It’s a reminder that there are many simple steps that we can all take to make life (or death in this case) just that little bit easier.
Talking about death is a morbid thing but it’s something that unfortunately escapes none of us. Therefore, the sooner we talk about it, the better it is for all concerned.
It’s also a good idea to talk about this subject because once you begin talking and learning, you soon realise that there are many options available where the Government, as unbelievable as it may sound, actually encourages you to reduce your tax burden. Yes, that’s correct, HMRC is happy if you take advantage of their incentive schemes and pay them less money.
You see the game of taxation and spending is a game of cat and mouse with one difference; the cat doesn’t want to eat the mouse. In fact, the cat probably doesn’t even want to make life uncomfortable for the mouse; it simply wants the mouse to play fair. The mouse is of course the individual person on the street, and the cat is the Chancellor of the Exchequer.
The important thing to note is that if the cat doesn’t want to eat the mouse, then we need to understand what role the cat wants the mouse to play. If we can figure that out then life just became a whole lot easier for the mouse.
Let me put it another way. The Government only has two ways in which it can encourage you to take an action, either through a great big, dirty stick or with a lovely, fresh carrot, or in the case of the Cat and Mouse, a nice piece of cheese. The problem is that because we are so accustomed to seeing the stick that we fail to see all of those delicious carrots that are dangled in front of us.
Okay, enough of the riddles. Let me explain in plain English.
What I am saying is this. Whilst the Government has no option but to tax us, it’s important to recognise that it also gives a significant number of tax breaks. The problem is that most people don’t take the necessary time to learn about the tax breaks on offer.
Inheritance Tax is a classic case for this.
IHT is arguably the most hated tax not just in Britain but around the world. Indeed, in recent decades many countries that previously charged IHT have now abolished it altogether.
Obviously, Britain hasn’t abolished it but it has given away so many tax concessions, that there is no reason why IHT cannot be either avoided entirely or significantly mitigated for most people.
Give it all to your Spouse
For example, if you wish to avoid IHT completely one way that you can achieve this is simply by ensuring that you give all of your assets away to your surviving spouse upon your death; this is known as the spousal exemption. Of course, this means that you need to be married and so if you are currently living in sin, now is the time to make an honest woman of your lady.
This also means that your spouse will take on your inheritance tax nil-rate band which is currently at £325,000. In other words when your spouse dies in the future his or her total nil-rate band will effectively become £625,000. In other words, there will be no inheritance tax to pay on any assets up to this figure.
But remember in order for this to work properly and for there to be no challenges raised by HMRC (especially when you are not here to counter them), you need to have legally drawn up wills in place which specifically detail that your assets are being passed over to your spouse upon your death. The will should also specify that upon the death of the surviving spouse, that the assets should pass onto your children.
Now that’s the first step but what happens if your estate is worth much more than the nil-rate band and let’s say you have an estate worth a few million?
Well, have no fear because surprisingly that is also a relatively easy one to fix too. But once again, you just need to know what those magical tax breaks are.
Investing your way out of IHT
In the case of larger estates, the main difference with smaller estates is that there is an element of risk involved. In other words, you can’t just write off a £1m tax bill without having some ‘skin in the game’. Life isn’t that easy, I’m afraid.
But worry not, for the good news is that the risk can be mitigated pretty effectively if you know what you are doing. In fact, it could end up as a great investment and besides you are already ahead by 40% before you even begin the race.
Before we get into any further riddles, let me explain.
One of the things that the Government seems very keen to do is to encourage small, start-up businesses to grow. Since the 2007/8 financial crash, banks have moved from excessive lending to very restricted lending. This has meant small businesses in particular are finding it more and more difficult to raise finance for their businesses. The Government recognises this fact and also that Small and Medium sized enterprises (SMEs) provide the backbone of the economy and engine for the country’s growth providing employment and spending.
And that’s where the clever tax incentive comes into play.
Because the Government doesn’t want small businesses to be starved of the working capital needed for expansion, it has now stepped in by encouraging private investors (people like you and me) to provide the finance that banks are unwilling to. The way that they encourage investors to do this is through tax breaks. In other words – if you agree to invest in a small company that it wishes to help then you don’t need to pay the Inheritance Tax.
It’s known as the Enterprise Investment Scheme (EIS).
Enterprise Investment Scheme (EIS)
In simple terms if you invest in a company which qualifies for an EIS status, any money that you invest, provided that you hold the investment for a minimum of 3 years, will no longer form part of your estate for Inheritance Tax purposes. Think about that for a second.
Let’s say you that you are £200,000 over the IHT threshold. This means that you can either pay 40% of the £200,000 (£80,000) to HMRC upon your death or you can invest £200,000 into an EIS investment and hold it for 3 years and pay nothing. Not bad.
Of course, you need to remember that small, start-up businesses are higher risk investments and instead of paying 40% you could end up losing 100%. That’s the risk.
On the other hand, if you invest wisely you could not only save on the IHT bill but also make money on the £200,000 investment.
If it does perform well and let’s say you double your money, the good news is that there is no capital gains tax on the profit. In other words, you have turned an £80,000 tax bill into a positive £400,000 which is completely IHT free.
EIS investments are also very effective schemes for mitigating income and capital gains tax bills. In fact, they are very popular for property landlords who want to avoid paying capital gains tax on properties that they have sold.
And even if the investment does perform badly the capital loss can be written off for tax purposes which will help to offset future capital gains.
Business Property Relief (BPR)
Another way of avoiding IHT is to invest in companies that qualify for Business Property Relief (BPR). Some companies on the Alternative Investment Market (AIM) qualify for BPR and if you buy and hold shares in these companies for more than 2 years, the money invested once again sits outside of your estate for IHT.
This strategy is very popular because firstly two years is a very short period of time to mitigate IHT and secondly it gives the investor the ability to actually make money on the investment.
How can you not love these tax breaks?
Now remember, there is a high level of investment risk with smaller, penny shares, which is why you need to choose the companies wisely.
However, you do have to choose pretty poorly to really mess things up.
That’s because in order for you to lose, the company that you are buying must fall by at least 40% (that’s the IHT bill you were going to pay) before you can lose anything. In the case of an EIS that number could be even higher depending on the other tax breaks you are benefiting from.
I’m not advocating putting all of your life-savings into small companies but it’s an option that is absolutely right for some people.
For example, if you have an IHT problem that you want to solve, you have just sold a property and have a capital gains tax bill to pay, you are a higher rate tax payer and feel that you are paying way too much in income tax, and you like the idea of potentially very big pay-offs by investing in small, start-up companies, well then yes – this type of strategy might just be for you!
The point is that there are strategies out there beyond the old-fashioned methods which include out of date and expensive strategy of setting up trusts or the very sloppy strategy of gifting money away under the 7-year rule.
Time to Learn more
Now remember that this report is a simplified, watered down version of a small part of what you need to know and as I mentioned at the beginning, this is not investment or tax advice. It is hopefully a wake-up call to do a little extra reading and speak to a tax advisor who will be able to guide you.
If you want to know more then get in touch with me at email@example.com
I am not a qualified tax advisor and so I won’t be able to advise you directly, but I do feel that I know enough to point you in the right direction.
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.