Beware the ISA Inheritance Tax Trap
This article was first published by Nucleus on 12 March 2021 and can be found at the following link:
https://illuminate.nucleusfinancial.com/blog/aim-relief-role-aim-investing-iht-planning
As advisers encourage clients to utilise their ISA allowances before the end of the tax year and for the new tax year, we see the usual round of news stories appearing on the number of ISA millionaires. While their number continues to grow, significantly more have accumulated hundreds of thousands of pounds over the 34 years that ISAs and their predecessors, PEPs, have been around.
But there is another side to this story, and one that could have significant tax consequences for ISA investors.
Most investors will be familiar with the favourable tax treatment of their ISAs, enjoying tax-free income and growth. So it’s understandable why some make the mistake of thinking that their ISAs are completely tax free. What many don’t appreciate is that on death, their ISA will be included as part of their estate for Inheritance Tax, and potentially be subject to a 40% tax charge. This would mean a large part of their beneficiaries’ inheritance being paid to the taxman instead.
But by planning ahead, and with the help of their financial adviser, action can be taken now to mitigate a potential IHT problem in future.
There are a number of well-established estate planning options available, each with their own pros and cons. One such solution is to invest in a portfolio of AIM company stocks which qualify for Business Relief. Since 2013, ISAs have been allowed to hold AIM company shares, opening up the prospect for both IHT relief and the potential for growth.
The AIM market has been around for many years and celebrated its 25th anniversary last year. It has been a major success story for the UK, helping nearly 4000 smaller companies raise capital to fund growth and development. Familiar names include Jet2, ASOS and Fever-Tree.
So, in terms of Inheritance Tax planning, how does this work?
Subject to stringent qualification rules, some AIM company shares may qualify for Business Relief. Providing an investor has held the shares for at least two years, and held them at death, the shares are expected to qualify for Business Relief and will not be subject to IHT.
There are caveats however. As with any form of tax planning there is always the risk that tax rules may change in future. And in addition to the usual risk warnings associated with smaller company investment, there is no guarantee that an AIM stock will qualify for Business Relief, as HMRC will assess every claim. That said, if the investor held a portfolio of AIM shares, one stock failure would not fail the whole portfolio.
Investing in AIM company shares for Business Relief is well established, and has been growing in popularity, for a number of reasons:
i) Relief is available after only two years. This is in sharp contrast to gifting, where the donor has to survive for seven years for the gift to be outside their estate. The two-year rule may therefore be attractive to those in later life, or with health concerns. Unlike some other estate planning solutions, there is no requirement for medical underwriting.
ii) The investor still retains control over their investment, and still has access should they wish to withdraw any capital. This may appeal to clients who are reluctant to gift assets and give up control.
iii) AIM IHT model portfolios are now available on many third-party platforms, allowing a client to consolidate AIM investment alongside their other investments. As well as the benefits of transparency and admin efficiencies, there can be significant cost savings too. When considering charges, where the AIM investment is held can make a significant difference to costs. Given that the purpose of IHT planning is to optimise wealth passed on to beneficiaries, it shouldn’t just be about the 40% saving in IHT. Reducing the overall impact of charges over the lifetime of the investment is also important.
Where AIM shares in an ISA have been held for Business Relief and the investor dies, the portfolio can be transferred to their spouse or civil partner using the Additional Permitted Subscription, without losing the IHT exemption. Where the deceased partner had not held their AIM shares for the full two years, the two-year holding period for Business Relief will continue without the need to restart after the transfer.
Estate planning tends to be left until later life, when clients may face a clear IHT problem. But what about younger clients who don’t have an a IHT issue at present, but potentially could in future? Perhaps now could be a good time for them to start IHT planning by using their annual ISA subscriptions to invest into an AIM IHT portfolio.
There are a number of other IHT planning scenarios where AIM investment for Business Relief may help clients. These include:
• Clients in later life with no, or inadequate, protection from IHT
• Clients facing the prospect of reduced life expectancy given their state of health
• Power of Attorney cases, where the attorney wishes to instigate IHT planning without requiring Court of Protection approval
• Clients who have sold their business in the last three years and where the proceeds of the sale give rise to an IHT liability
• Clients looking to settle assets into trust
Investing for Business Relief is becoming more mainstream in estate planning due in part to the flexibility it brings. And as a lifetime investment, it gives financial advisers the opportunity not just to maintain their existing client relationships, but to nurture new relationships with the next generation.
The past year has been a testing time for everyone in all sorts of ways and for many it has made them more aware of mortality than previously. As lockdown restrictions begin to ease and better weather returns, now may be an appropriate time to address Inheritance Tax planning.
David Holmes
Head of Business Development