How to deal with shares in a personal service company where the cash reserves have built up to such an extent that IHT business property relief would be restricted or denied altogether. Terry Jordan writes for Taxation magazine.
Inheritance tax implications of a gift of money and the receipt of rent-free housing
Margaret and James are married and aged 66 and 70 respectively. Their total estate is worth about £2m. They are based in the UK and their only child, Sam, is 26.
Their only residence is worth about £1.25m. They would like to sell this and move nearer to their son (in the UK) and live in a property worth about £750,000.
Sam is also UK-based, but does not own a house at present, having always lived in rented accommodation. It has been suggested that they gift him £750,000 and he would use that money to buy the new property in his name.
This would be his main residence and he would allow his parents to live with him rent-free, granting them no lease or security of tenure.
In the parents’ minds, the £750,000 would be a gift to Sam and the seven-year inheritance tax clock would start ticking. Sam is not in a relationship at present, but if circumstances changed he could buy a second UK property.
He would live in that second property, but would nominate the first one (occupied by his parents) as his main residence.
Margaret and James are well aware of the pitfalls of having no legal right of occupation in Sam’s home and the potential financial pitfalls and problems that might be caused if a future relationship of Sam were to break down.
However, they are prepared to take the risk if it saves Sam £300,000 inheritance tax (ie 40% of £750,000) on their death.
Would the above scenario be classed as a gift with reservation unless they paid Sam a commercial rent? If it is, could this obstacle could be overcome and how?
Query 18,453 – Dave
Reply from Terry “Lacuna” Jordan, BKL
As long as the parents survive for the normal seven-year period, potentially exempt transfers (PETs) would fall off their inheritance tax clocks.
As the value of the gifts is not much more than their nil-rate bands, once the parents had survived the gifts by three years, inheritance tax “taper” relief would not be of much practical benefit because it reduces the tax on the failed PET, not the capital value.
One of the perceived flaws in the old estate duty concept of gifts with reservation of benefit that was reintroduced with inheritance tax in 1986 and is contained in FA 1986, s 102 and Sch 20 was that it did not trace through gifts of cash.
Accordingly, unless HMRC could use the “associated operations” provisions in IHTA 1984, s 268 the cash gifts would not be gifts with reservation of benefit.
However, that is not the end of the story. The treatment of cash gifts was one of the drivers behind the introduction, with effect from 6 April 2005 by FA 2004, s 84 and Sch 15, of the income tax charge on pre-owned assets (POAT).
In this case, the parents would be occupying the property and they would clearly be caught by the “contribution” condition having been the source of the purchase price.
Accordingly, unless they paid full consideration for their occupation under a legally-binding agreement, they would be liable to income tax on the open-market rental value of the new property.
While not a complete answer, the “sharing” provisions in FA 1986, s 102B(4) could be in point for as long as the son occupied the new property were it to be jointly owned. The parents would also be outside the POAT charge.
When the son ceased to occupy, the parents could pay full consideration (that does not necessarily have to be rent taxable as such in the son’s hands).
Some tax counsel are of the view that the sharing provisions can be in point even if the donors retain a minimal percentage share in the subject property.