The elephant trap
‘Executors have no need to consider the tax consequences for beneficiaries when income distributions are made; beneficiaries should be grateful for what they get.’ Some may take that view but better practice should include consideration of the consequences that arise when the aggregate of estate income distributions and other income takes an individual into higher rates of tax because they may incur additional costs. This result is more likely if estate income is paid as a single payment once the estate has been wound up, particularly in estates that have taken time to finalise.
Those extra costs are currently, as a minimum, a liability to higher rate tax and possibly the cost of employing an advisor to complete a tax return. As will be seen below, however, the announcement of Child Benefit clawback from, probably, January 2012 may impose further costs that may be in excess of the income actually received.
If an individual is close to the higher rate threshold (2011/2012 GBP42,475 – announced 2 December 2010) then it will be generally better to distribute income on an annual basis to ensure a beneficiary remains below the higher rate threshold. The examples below use 2011/2012 tax rates and allowances simply because that is the only future year we have information on, but the principles illustrate the concerns.
Janet normally earns GBP42,000; in 2011/2012 after Personal Allowance (GBP42,000 - GBP7,475) her taxable income is GBP34,525 so she is a basic rate taxpayer because basic rate in 2011/2012 ends at GBP35,000. Janet cannot control when executors distribute, but in 2011/2012 she is approximately GBP475 short of higher rates; that is her normal situation.
If she received GBP2,000 (gross equivalent) from an estate when it was wound up as a single payment she will be liable to higher rates on some of that income whereas, if the estate income were paid out over a number of tax years, it is possible no higher rate liability will arise.
It seems sensible to ask beneficiaries if they would prefer income evenly over the administration period. A beneficiary on the margin of higher rates may remain a basic rate payer with interim payments, but not if a single payment is made.
Two recent announcements have made the indicated best practice a better option. Firstly, the announcement that from 2011/2012 the Personal Allowance is to increase to GBP7,475, as part of the government’s ambition to increase the allowance to GBP10,000 by the end of the current parliament, but higher-rate taxpayers will not get the benefit of the increase. Accordingly the higher rate threshold is reduced from GBP37,400 for 2010/2011 to GBP35,000 in 2011/2012.
Secondly, the announcement that from 2013, probably January 2013, Child Benefit is to be withdrawn from any family containing a higher rate taxpayer, will mean the receipt of even GBP10 of estate income to an individual right on the margin of higher-rate tax would cause Child Benefit of GBP1,055 for the first child and GBP696 for subsequent children to be withdrawn; a very high marginal rate of tax.
Hannah is a director of her own company. With the aid of her accountant she ensures her income is below the higher rate threshold by GBP500 every year.
She has two children and so currently receives GBP1,751 in Child Benefit. In 2013/2014 the executors of her grandmother’s will distribute estate income of GBP600 (gross); this takes her (just) into higher rates. Even though she is only into higher rates by GBP100 she loses all entitlement to Child Benefit for that year.
How can you avoid the elephant trap?
Firstly, by establishing which estate beneficiaries are at the higher rate margin. If they are, then consider paying income out each tax year as it arises, if that keeps them out as basic-rate taxpayers. Even if they are already a higher-rate payer, it probably makes sense to distribute as much as you can before 6 April 2012 in case their circumstances change in 2012/2013 and entitlement to Child Benefit thereby preserved.
We should suggest beneficiaries contact us regularly as their circumstances change because, for example, if Hannah has no partner to whom her estate entitlement can be transferred, it may be better to take the hit in one tax year to avoid Child Benefit being lost over a number of years; in that circumstance accumulating income to be paid out as a single sum produces a better result. If nothing else, the UK government’s announcements concerning Child Benefit confirm that tax is never the only question (or answer).
The changes for 2011/2012 to the higher-rate threshold suggest, given the government’s ambition to increase the personal allowance to GBP10,000 over the lifetime of this parliament, that future personal allowance increases may also be clawed back from higher-rate taxpayers. Accordingly it cannot be assumed that the higher rate threshold will remain at the 2011/2012 indicated level of GBP35,000, taxable income of GBP42,475.
If a family unit consists of one taxpayer close to the threshold and a second with lower income, should an estate be varied to direct capital and income to the lower income individual?
These changes also suggest that when we write to beneficiaries, advising them of their good fortune, that we should enquire whether they are in receipt of Child Benefit, whether anyone in their family is a higher-rate taxpayer, and if not, how close to the threshold are they?
Clawback is a possibility
If nothing has been done and a beneficiary falls into higher rates, are there cost-effective methods of avoiding that consequence and hence avoiding Child Benefit clawback?
One solution will be to extend the basic-rate band either by making a charitable gift under ‘Gift Aid’ or by additional personal pension contributions. In either instance if higher-rate tax relief is due, the mechanism for granting relief is to extend the basic-rate band so higher rates would begin above GBP35,000 (in 2011/2012).
Isla and George are married with two children. Isla has a part-time job with earnings of GBP10,000; George earns GBP42,250 as a pest control operator.
His taxable income is just below GBP35,000 (GBP42,250 - GBP7,475 = GBP34,775) but if George receives GBP500 gross income from his aunt’s estate his revised taxable income of GBP35,275 now exceeds the GBP35,000 higher rate threshold; the family’s entitlement to Child Benefit is at risk.
George donates GBP240 (net) to the RSPCA as a Gift Aid payment. The charity recovers the GBP60 tax ‘deducted’ from the payment because George has made a gross payment of GBP300. Accordingly George’s basic rate band is then extended by GBP300 to GBP35,300 so he is no longer a higher-rate taxpayer and Child Benefit is preserved.
Even if the higher-rate liability is not discovered until after the end of a tax year all is not lost; it is possible to elect to carry back a ‘Gift Aid’ payment to the previous year provided the election is made before the tax return for the relevant year is submitted.
Thus, if the clawback arises in 2013/2014, if George made the‘Gift Aid’ payment in July 2014, made the carry back election in August 2014 and submitted his tax return in September 2014 the payment could be carried back to 2013/2014.
A similar result can be achieved with additional personal pension contributions, but in that instance, the payment has to be made in the relevant tax year. There is no provision to allow carry back of pension contributions.
If an estate administration has meandered and a single accumulated payment of income made after 5 April 2012 takes an individual into higher rates, resulting in Child Benefit clawback, affected beneficiaries will be less than sanguine at the conduct of the executors. Anyone affected will, at best, be disgruntled and at worst seek compensation.
Will there be any suggestion of negligence that might be avoided by establishing standard procedures to write to beneficiaries annually to try, if possible, to avoid the clawback trap. Certainly there will be much in both the professional and popular press as to the consequences of becoming a higher-rate taxpayer and how clawback of Child Benefit might be avoided. Establishing systems now to review the tax position of beneficiaries, and being proactive to try to retain Child Benefit, should be a standard procedure.
Although there is still some time before claw back applies, assuming it becomes law, there will be current estates that will not be finalised before January 2012. Starting a better practice now should ensure fewer pitfalls ahead. Of course, beneficiaries may be reluctant to disclose their personal situation, but offering advice, even if it is refused, should take advisors out of the firing line and that ultimately is the reason why we establish systems of best practice.
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