Can I leave my estate to my nieces free of inheritance tax?

I’m in my late seventies and while I’m in excellent health, I have decided to leave my entire estate — worth about £2m including my house — to my two nieces whom I am very fond of. I never wanted children so it seems unfair that, since my nieces are not my direct descendants, they will face a large inheritance tax bill. Is there any way around this?

Liz Cuthbertson, a private client tax partner at accountants Mercer & Hole, says that if you do nothing your taxable estate will be subject to inheritance tax (IHT) at 40 per cent when you die. The tax will be calculated after deducting any available reliefs.

Every individual has a nil rate band for IHT which is currently £325,000. As you say, your estate cannot benefit from the residence nil rate band because your property will not pass to direct descendants.

Assuming that at the time of your death the nil rate band has not been used — for reasons such as gifts made during your lifetime that exceed your tax-free allowances — your £2m estate will be reduced by £325,000 to £1.675m which will be subject to IHT at 40 per cent.

You are in good health and in your late seventies. Depending on its affordability and the composition of your estate, you could consider making a gift to your nieces during your lifetime with the aim of reducing the overall value remaining on your death.

You need to ensure you leave yourself with sufficient funds for your own lifetime including potential future costs, but it is worth considering whether you have scope to make gifts in your overall circumstances.

If you can, gifts can be a straightforward and effective way to enable your nieces to benefit now and reduce the IHT burden on your estate subject to the relevant conditions being met.

Some gifts are exempt from IHT and reduce your estate immediately. An individual can make annual gifts of up to a total of £3,000 per year without being taxed on that amount.

You can make additional gifts — that are exempt from IHT — provided all the relevant conditions are met. You need to demonstrate that the gift is made out of your surplus income and does not reduce your own standard of living. Gifts out of income must also be part of your normal expenditure, so a regular pattern of making such gifts should be established. You should take advice on this to ensure you can meet all the relevant conditions.

If gifts are not IHT exempt they are called potentially exempt transfers (PETs). A PET will not incur IHT if you survive a full seven years from the date of the gift. If you make a PET and do not survive the full seven years, the gift will reduce the nil rate band available on death. There will be some partial relief against the IHT charge if you die three years after making the gift and will increase the longer you live — on a tapered basis.

A further, but more drastic, possibility would be to downsize and make a more substantial gift out of the net proceeds while taking care to retain sufficient means to meet your own needs.

Lilly Whale, a solicitor in the private client team at law firm Goodman Derrick, says since you have no children, and assuming you have no living spouse, alternative estate planning methods should be considered rather than relying solely on the £325,000 nil rate band and £175,000 residence nil rate band (RNRB) to reduce your IHT bill.

You can gift any sum of money during your lifetime without incurring an immediate IHT liability. The value of the gift will remain in your taxable estate for seven years from the date it is made; provided you survive seven years, it will not attract an IHT charge. If you fail to survive seven years, the gift becomes chargeable and will use up all or part of your £325,000 nil rate band depending on its value. If you die between three and seven years, IHT is reduced by a mechanism called taper relief.

Additionally, you have a £3,000 annual exemption for gifts out of capital. This can be backdated to cover any unused exemption from the previous year. Accordingly, your nieces could start to benefit from your estate now, and your estate would reduce year-by-year — meaning a smaller IHT bill on death.

You could consider gifting out of net income, which allows you to make regular gifts monthly or quarterly out of surplus income to whomever you like without triggering an IHT liability since you are essentially freezing your estate by not causing it to increase in value. It is vital you do not dip into your capital to meet normal outgoings as a result and you must be able to maintain your usual standard of living, otherwise on your death HM Revenue & Customs will not allow this relief to be claimed.

If you have made no annual lifetime gifts over £3,000 then your full £325,000 nil rate band should be available on death. If you are widowed, your estate would be entitled to transfer the unused nil rate band of your late spouse/civil partner, regardless of how long ago they died.

The additional RNRB can be claimed if an estate is left to direct descendants — siblings, nieces, nephews, cousins cannot benefit. Regrettably, leaving your estate to your nieces rules this out. In any event, RNRB is tapered for estates above £2m and disappears entirely for estates over £2.7m.

Occasionally, individuals believe that if they are not leaving a spouse or children behind, there is no point in estate planning: that is not the case. Estate planning is arguably more restricted without the RNRB or spouse exemption — assets passing entirely to spouses are free from IHT — and clearly both tax reliefs disfavour those who are unmarried or childless, as there is no viable equivalent.

There are nevertheless many options to consider so that your wealth is not completely diminished on death in HMRC’s favour: the more time you give to estate planning now, the greater chance you have of reducing your IHT bill for your beneficiaries.

The opinions in this column are intended for general information purposes only and should not be used as a substitute for professional advice. The Financial Times Ltd and the authors are not responsible for any direct or indirect result arising from any reliance placed on replies, including any loss, and exclude liability to the full extent.

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