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According to recent research by unbiased.co.uk, Britons will pay over £2 billion in inheritance tax (IHT) this year, but with careful planning you can avoid this most hated of taxes...

What is IHT?

Inheritance tax (IHT) applies to everything in a Contractors or perhaps your parents estate. The tax falls upon property, savings, investments and a persons share of jointly owned assets that together add up to more than the nil-rate band of £325,000 (for 2009/10). Anything above this nil-rate band is charged at 40% which would be £70,000 on an estate worth £500,000.

The good news is that in October 2007, a transferable nil-rate band was introduced which allows married couples and civil partners to transfer any unused nil-rate band to the surviving spouse, allowing couples to save on IHT when they die. This may not cover all of your or your parents IHT liability so there are other ways of reducing the tax using forward planning.

Plan Ahead

IHT is sometimes referred to as a voluntary tax because there is so much that you can do to avoid it. Contractors or your parents can substantially reduce your estates and therefore your IHT liability by giving it away prior to your death. If a person lives for seven years after gifting away part of their estate and no longer reserves any right to that gift, then it won't be classed as part of the estate and you escape the IHT on it.

These gifts are referred to as potentially exempt transfers (PETs) and they are particularly beneficial as any growth is immediately outside your estate despite the gift taking seven years to leave. This means that if, for instance, your house were to rise in value over the next seven years you wouldn't be charged IHT on the growth despite it still officially belonging to your estate until the seven years has passed.

Alongside these PETs there are a number of other exemptions that you can use to minimise your exposure to IHT:

- An annual gift of up to £3,000
- An unlimited number of gifts per year that are below £250
- Gifts for marriage between £1000 and £5000 calculated according to your relationship with the couple
- A sums paid from your income to another individual. This is unlimited as long as it is a regular payment and it doesn't affect your standard of living.

All of these exemptions are classed as immediately outside your estate although you must ensure that you document them fully. The other alternative is to invest in trusts for your beneficiaries.

Trusts

If you want to make provisions to minimse your future IHT bill but you don't want to lose control of your estate completely then a trust could be for you. There are a variety of trust schemes that enable you to reduce your IHT liability whilst still retaining some control over the assets and this may be particularly beneficial if your intended beneficiaries are very young. They are also relevant if beneficiaries are about to divorce and would otherwise lose some of the assets.

Like PETs, most trusts can take seven years to leave your estate as far as IHT is concerned but crucially, the trustees are able to alter how the trusts assets are distributed and as such there is more flexibility. There are also trusts that allow you to provide an income for you and others that enable some of the assets and any growth to be immediately classed as outside of your estate.

The wide variety of options available makes IHT and trusts in particular, a very complicated subject. It is essential to seek expert advice before considering a trust as there are a number of different options available, enabling you to tailor your tax planning to your individual circumstances.

Your home?

Possibly the most difficult decision to make in terms of your IHT planning is what to do about your property. For many of us, our home is our biggest asset and as such it stands to be the area most affected by IHT. However, you also need a home to live in and gifting away your primary residence can be a worrying prospect.

The reason that property is the most complicated area of IHT planning is that many of us wish to continue living in our property until we die. However, if you gift your home to your children but continue living there then you will be 'reserving benefit' which means it will never fully leave your estate and IHT will still apply. To add insult to injury, your children could end up paying capital gains tax if they don't use the house as their primary residence which would put them in an even worse position.

In order to avoid this you could give or sell your property to your children and pay rent to them in order to continue living there. Whilst this would mean the house would leave your estate after seven years, it would also mean that the rent you pay your children would be classed as income and they would be taxed accordingly.

One solution is for the child to live in the house with you and the you can give half the house to them. As long as the child shares the running costs of the property then HMRC will class your estate as owning half the property which reduces your IHT. If this isn't possible then you could use borrowing (known as 'equity release') to reduce the value of your estate and either spend the money or gift it to your beneficiaries.

Seek expert IHT advice

The variety of options available for IHT planning can be quite confusing and it is vital that Contractors or their parents get it right in order to minimise the amount of your hard earned assets that can be stripped away by HMRC.

The expert advisers at Contractor Financials can help you to make the most of your IHT planning and ensure that your assets fall into the hands of your beneficiaries rather than those of the tax man. If you would like advice on your IHT needs then simply fill in the form below, and the team will get back to you shortly.