If you can afford to do so, making inheritance tax gifts e.g gifting money before death or passing on assets to family members or loved ones, can be an excellent way of ultimately paying less to the tax man.
Whilst we are all free to do this whenever we want, this blog aims to demystify and raise awareness of the potential important implications surrounding Inheritance Tax, which can be very complicated.
These types of inheritance tax gifts (or IHT gifts) are known as ‘lifetime transfers’. The two main types are “Potentially Exempt Transfers” (PETs) and “Chargeable Lifetime Transfers” (CLTs) both of which are outlined below.
Here is an overview of the content covered in this article (if there is a particular section of interest, you can click on the item to jump straight to it).
PETs are lifetime gifts made directly to other individuals, usually family members and close friends, but can also include special types of trusts for grandchildren.
Not all inheritance tax gifts qualify as PETs, instead they are known as chargeable lifetime transfers (CLT), which are covered in the next section of this article.
Please note: Gifts to a spouse are exempt, so are not subject to Inheritance Tax.
What is the 7 year rule in inheritance tax?
When you make a PET whilst you are still alive, you must survive for at least seven years to ensure the person who received the gift has full exemption from inheritance tax.
A CLT is a gift by way of a trust.
If the CLT exceeds the available Nil Rate Band (NRB) when it is made, this results in a lifetime Inheritance Tax liability of 20% of the value above the NRB, payable by you, the giver of the gift. Also, failure to survive for seven years results in the value of the CLT being included in your estate in the same way as PET. If the CLT is subject to further Inheritance Tax on death, a credit is given for any lifetime Inheritance Tax paid.
Anyone using PETs / CLTs for tax mitigation purposes, should consider the consequences of failing to survive for seven years. Such an assessment will involve balancing the likelihood of surviving for seven years against the tax consequences of death within that period.
Failure to survive for the required seven year period results in the full value of the PET / CLT transfer being notionally included back in the estate as if it never left in the first place. Survival beyond seven years means nothing is included in the individual’s estate.
It is taper relief which reduces the Inheritance Tax liability on a sliding scale (not the value transferred) on the failed PET after its full value has been returned to the estate. The value of the PET itself is never tapered.
Sliding scale is dependant on the length of time from giving the gift to death
The amount of Inheritance Tax payable is not static over the seven years prior to death. Rather, it is reduced according to a sliding scale dependant on the length of time from the giving of the gift to the individual’s death. (see table below)
No relief is available if death is within three years of the lifetime transfer.
|Time Between Date of Gift & Donor’s Death||Taper Relief Applied To Tax Due||Effective Rate On Gift|
|0 – 3 years||0%||40%|
|3 – 4 years||20%||32%|
|4 – 5 years||40%||24%|
|5 – 6 years||60%||16%|
|6 – 7 years||80%||8%|
These are dealt with in a chronological order upon death:
Earlier transfers are dealt with in priority to later ones, all of which are considered before the death estate.
If a lifetime transfer is subject to Inheritance Tax because the NRB is not sufficient to cover it.
The next step is to determine whether taper relief can reduce the tax bill for the recipient of the PET.
The Tax Treatment of Chargeable Lifetime Transfers
The tax treatment of CLTs has some similarities to PETs but with a number of differences as follows:
When a CLT is made, it is assessed against the donor’s NRB. If there is an excess above the NRB, it is taxed at 20% if the recipient pays the tax or 25% if the donor pays the tax.
The same seven-year rule that applies to PETs then applies. Failure to survive to the end of this period results in Inheritance Tax becoming due on the CLT, payable by the recipient.
The tax rate is the usual 40% on amounts in excess of the NRB, but taper relief can reduce the Inheritance Tax bill, and credit is given for any lifetime tax paid.
Potentially increasing the Inheritance Tax bill for those that fail to survive for long enough
The seven-year rules that apply to PETs and CLTs potentially increase the Inheritance Tax bill for those that fail to survive for long enough after making a gift of capital. If Inheritance Tax is due in respect of the failed PET:
Is payable by the recipient.
If Inheritance Tax is due in respect of a CLT on death, its payable by the trustees.
Any remaining Inheritance Tax is payable by the estate.
The potential Inheritance Tax difference can be calculated and covered by a level or decreasing term assurance policy written in an appropriate trust for the benefit of whoever will be affected by the Inheritance Tax liability and in order to keep the proceeds out of the settlor’s estate. Whatever is more suitable, and the level of cover required, will depend on the circumstances.
Covering the gradually declining tax liability that may fall on the gift recipient
If the PET or CLT is within the NRB, taper relief will not apply. However, this does not mean that no cover is required. Death within seven years will result in the full value of the transfer being included in the estate. A seven-year level term policy may be the most appropriate type of policy in this situation.
Any additional Inheritance Tax is payable by the estate, so a trust for the benefit of the beneficiaries of the estate will normally be required.
Where the PET or CLT will exceed the NRB, the tapered Inheritance Tax liability that will result from death after the PET or CLT was made can be estimated, and a special form of ‘gift inter vivos’ (a life assurance policy that provides a lump sum to cover the potential Inheritance Tax liability that could arise if the donor of a gift dies within seven years of making the gift ) is put in place (written in an appropriate trust) to cover the gradually declining tax liability that may fall on the recipient of the gift.
A Level Term Assurance policy written in an appropriate trust
Trustees might want to use a life of another policy to cover a potential Inheritance Tax liability. Taper relief only applies to the tax.
The full value of the gift is included within the estate, which in this situation will use up the NRB that becomes available to the rest of the estate after seven years.
Therefore, the estate itself will also be liable to additional Inheritance Tax on death within seven years, and depending on the circumstances, a separate level term policy written in an appropriate trust for the estate beneficiaries might also be required.
Where an Inheritance Tax liability will continue after any PETs or CLTs have dropped out of account, Whole of Life cover written in an appropriate trust can also be considered.
As you may have gathered, inheritance tax gifts are highly complex in the UK, but handled correctly can significantly reduce inheritance tax ensuring your loved ones (not the tax man!) get the maximum benefit from your estate. To find out more, speak to experienced Cardiff-based Estate Planning Adviser Tony Thomas on 07585 592494 or firstname.lastname@example.org