Tax on divorce
You may understand the concept of tax planning when it comes to thinking about your death but it is less common to hear that you should also be considering tax planning prior to your marriage or civil partnership and also in the event of a divorce or dissolution. In the following article for ease of reference, we will use the example of ‘spouses’ and ‘marriage’ however everything referred to applies equally to those who are married or are civil partners. In this article we seek to highlight some key considerations. Please note that the comments in this article should not be taken as financial advice and if any of these issues resonate with you, you should seek specific advice.
Tax and your marriage
Your parents (or other individuals) may wish to help you on the road to married life and provide funds to assist you with the purchase of your first home. How those funds are going to be provided will be key to their treatment in the future and you should discuss the options candidly with your parents:
- Loan – This provides for repayment but needs to be properly documented with interest provisions identified and a repayment schedule put in place to ensure that it is clear as a loan. This will not provide any tax planning benefits for your parents as the money remains theirs and falls into their estate in the event of their death.
- Gift – This may provide tax planning benefits for your parents but does not protect the funds from your spouse in the event of a divorce. You may need to consider a pre-nuptial agreement before marriage if you wish for the funds to be protected in the event the marriage does not succeed.
- Trust – These have been used for many years as a tax planning option with the benefit of protecting the underlying assets for the longer term. The rules on trusts are complex and you must get specific advice on these, particularly as the trust can fail to protect funds from your spouse in the event of divorce if the sole purpose is to put funds out of their reach.
Tax and your home
Capital Gains Tax (CGT) is applicable on the ‘disposal’ of a capital asset. This includes your home but there is a relief against the tax if it is your principle private residence (PPR). Currently this relief applies for the whole period of your occupation in the property plus the last 18 months of ownership (irrespective of whether you were in occupation during those months but only if you have not purchased another property and elected that as your PPR). This extension of 18 months can be key when one spouse moves out of the family home prior to divorce and there is a later sale or transfer of the family home. There are plans for this extended period to be reduced to nine months from 6 April 2020.
In some cases, it is possible to make a claim to HMRC to claim a CGT relief if the family home you left over 18 months ago is being transferred to your spouse who remained in the home. There are technical rules which apply to this and so you should seek advice if this scenario is appropriate to you.
PPR does not apply for a second property and you must, therefore, ensure that you have considered and dealt with who is going to pay the CGT which arises on the disposal of that property.
Tax and the timing of separation
Divorce often leads to asset transfers following the division of matrimonial finances. Transfers between spouses can be done without charge to CGT up to the end of the tax year of separation. How long this gives you will depend on when you separate. If you separate on 1 April, you have a matter of days to make these transfers which may prove impossible. You obtain the most time to consider tax efficiency if you separate on 6 April in any year.
If you are not able to agree the transfers prior to the end of the tax year of separation, you should take advice as to the most tax efficient way to transfer those assets to minimise any CGT. This may include spreading the transfers over two tax years to take advantage of your annual CGT exemptions (£12,000 in tax year 2019 / 2020).
Tax and the family company
It is common for spouses to set up the family company with both spouses as shareholders to enable the income to be divided between them in a way which takes advantage of income tax allowances (currently £12,500 in tax year 2019 / 2020). The way the company is run during the marriage usually means that income is extracted from the company and paid into a joint account with the accountant dealing with the relevant dividend declarations at the end of the year.
You need to be aware, however, that in the event of a separation / divorce this can cause difficulties in the management of the income from the company as both spouses are entitled to share in any dividends declared. You must ensure you understand how the income is extracted from the company and that you are not falling foul of the requirements of a company and your own requirements regarding income tax.
In addition, transferring shares in the family company can lead to a capital gain. There are some tax reliefs available to certain types of shares and this should be explored with the relevant advice.
Tax on your death
Many married couples prepare their wills together to make the best use of tax planning. They often mirror the provisions of each other and typically provide for everything to pass to the spouse in the first instance and then to any children in the event their spouse has died.
Mitigating exposure to inheritance tax is a common concern for individuals, especially if they wish to ensure their estate is preserved and protected for loved ones or the next generation. Individuals have a £325,000 inheritance tax allowance (the Nil Rate Band), and subject to certain criteria, you could also have an additional £150,000 inheritance tax allowance known as the Residence Nil Rate Band (rising to £175,000 in April 2020). Where your estate exceeds these allowances, a 40% rate of inheritance tax will apply unless any other allowances or exemptions are available.
Between spouses, these allowances can be transferred to the extent they remain unused. The result of which means that advice regarding wills and trusts for spouses can be very different than that given to a single person. The primary reason being that ‘spouse exemption’ against inheritance tax applies when assets pass between spouses, and so this can be taken advantage of to mitigate tax when one party to the marriage dies.
Post separation but pre-finalising your divorce, you may also consider striking a balance between protecting assets for your children and maximising tax efficiency. By way of example, if you jointly own your family home with your spouse then this could pass to them automatically irrespective of the terms of your will. This is tax efficient but may not be what you wish to happen. If this is your situation, you should take advice about severing the joint tenancy on your family home to ensure it falls within the scope of your will.
Unlike entering into a marriage, divorce does not revoke a will but instead provides for your will to be read as if your spouse died on the date of divorce. It is therefore essential to review your affairs to ensure they are structured in the most tax efficient manner for your remaining beneficiaries. You should consider this both during your separation and after your divorce becomes final.
To take no action following divorce could result in various complications for your family, the most common being that you no longer have an effective executor appointment clause (if your former spouse was your sole named executor), assets could pass to your children or other family members at an unsuitable time (eg when your children are still very young), or the provisions do not qualify for beneficial inheritance, income and / or CGT treatment.