This article provides a brief overview of some of the rules and Inheritance Tax implications associated with common ways of giving.
An outright gift falls into one of two categories, depending the type of gift and to whom it’s made. These categories are: Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs)
Potentially Exempt Transfers (PETs)
This is a gift that might become entirely free of any inheritance tax liability: hence potentially exempt. For the gift to be exempt the donor must survive for seven years after making the gift.
PETs can be of unlimited value and are usually outright gifts of cash or assets to an individual or into an ‘Interest in Possession Trust’. Transfers into other types of trusts will probably be Chargeable Lifetime Transfers are dealt with differently.
If the donor dies within seven years of making a PET, the transfer will be included in the estate for IHT purposes and charged the full 40% rate.
Gifts from surplus income
An exemption also applies where an individual can prove that the gift was made from the donor’s ‘income in excess of normal expenditure’ providing certain conditions are met including; (the gift) was made from income, and; left the ‘transferor with enough income to maintain their standard of living’.
Whilst not providing firm guidance, HMRC’s Inheritance Tax manual states that these gifts need to be regular and an individual ‘must show the pattern of giving’. And ‘a reasonable span would normally be three to four years.
It is common for expenditure to be complicated and unpredictable so assessing the eligibility for this exemption will be on a case by case basis. Taking legal and financial advice is therefore sensible.
Small Gifts Exemptions
There are a number of small gifts an individual can make each year, which are free of IHT; for example, the £3,000 annual exemption. These should be explored if affordable.
Chargeable Lifetime Transfers (CLTs)
Gifts or transfers into discretionary trusts are Chargeable Lifetime Transfers (CLTs).
A CLT is a gift that is immediately assessable for Inheritance tax. (The reasons why HMRC treat these two types of trust differently are too complex to deal with in this article.) If the combined value of any CLTs made in the last seven years exceeds the £325,000 nil rate band then an Inheritance Tax charge of 20% will be liable on the excess.
There are also periodic charges of 6% of the value of a discretionary trust, which is in excess of the nil-rate band, every ten years. And an exit charge of 20% of the value of a discretionary trust, which is in excess of the nil-rate band, when assets are finally distributed out to of the trust.
If the donor or settlor of the trust dies within seven years of making a CLT, the transfer will be included in the estate for IHT purposes and charged the full 40% rate.
The 7-year rule and PETs
The reasons PETs are only potentially exempt is that if the donor dies within seven years of the gift being made, it becomes a ‘failed PET’ and is taken into account for the IHT calculation on death.
If the PET fails, then there could be Inheritance tax to pay. The inheritance tax rate is reduced on a sliding scale, the longer an individual survives after making a gift. If the donor survives for seven years, the gift will be wholly excluded from the Inheritance Tax calculation.
|Years between gift and death||Tax paid|
|Less than 3||40%|
|3 to 4||32%|
|4 to 5||24%|
|5 to 6||16%|
|6 to 7||8%|
|7 or more||0%|
Lyndsey gifts £400,000 to her daughter Emily in 2015 and a rental property in South Cerney worth £500,000 to her son Owen in 2017.
Immediate IHT Position:
- Total gifts are £900,000
- The gifts were made to individuals so are classed as PETs so there is no immediate tax charge to consider
- PETs can be of unlimited amounts
- Each PET has its own seven year period. The gift to Emily will ‘fall out’ of any IHT calculation on Lyndsey’s estate in 2022; Owen’s in 2024.
IHT Position if Lyndsey died in 2023:
- Lyndsey will have survived for seven years after the gift to Emily, so is excluded from any IHT calculation on Lyndsey’s estate, however;
- Her death was only six years after her gift to Owen, so it will use up all of her £325,000 nil rate band and £175,000 will suffer an inheritance tax charge of 8% (£14,000 tax to pay).
The 7 year rule and CLTs
What might be the IHT implications if we used the example above, but replaced the gifts directly to her children, with gifts to discretionary trusts?
Lyndsey gifts £400,000 to a discretionary trust in 2015 and a rental property in South Cerney worth £500,000 to a discretionary trust in 2017.
Immediate IHT position:
- £400,000 gift to a trust in 2015 is £75,000 more than the nil rate band, bringing an immediate IHT charge of £15,000 (£75,000 x 20%).
- Either the trustees can pay the Inheritance Tax or the settlor (Lyndsey) can. If the settlor pays, this tax payment will also be assessable for IHT as it is considered a further loss to the estate, as follows:
- £75,000 ‘grossed up’ by 20% = £75,000 / 0.80 = £93,750.
- £93,750 x 20% = £18,750
- As the transfer of the £500,000 property to trust is made only a year later, there is no remaining nil rate band, so the full £500,000 is liable for IHT, giving rise to a charge of £100,000 (£500,000 x 20%). Again, this would be more if Lyndsey paid it. (Imagine the dilemma if the only gift to trust was the house.)
IHT Position if Lyndsey died in 2023:
- The first gift to trust in 2015 falls out of the estate and is not included in any IHT calculation.
- The gift of the property into trust in 2016 forms part of Lyndsey’s estate and is assessable for IHT.
- As death was 6 years after the gift was made, taper relief applies and IHT rate of 8% is levied (£40,000). Even though the IHT liability on death is less than the tax of (at least) £100,000 already paid, there will be no refund.
IHT Position if Lyndsey died in 2018:
- Both gifts are fully assessable for IHT with no taper relief applied.
- At least £115,000 IHT has already been paid
- As the first gift exhausted the nil rate band, tax will be calculated on the full death rate of 40% on the £575,000 (£75,000 from the first gift, £500,000 from the second).
- Total tax due would be £230,000 (£575,000 x 40%). However, £115,000 has already been paid, so only an additional £115,00 is due.
Instead of gifting, a donor could lend assets to an individual or trust. This would not be classed as a PET or CLT ad would have no impact on other gifts or the nil rate band.
If one were in the position to make many gifts over the course of several years, the timing and manner of each gift will have complex IHT implications, the details of which are beyond the scope of this article. Again, it is sensible to seek advice from an estate planning professional before making significant gifts.
This article provides a brief overview of these gifts but there are many other considerations to be borne in mind for when devising a holistic estate planning solution .
Instructing the services of a solicitor and/or an estate planning professional is recommended when mitigating an inheritance tax liability.
Whilst tax mitigation is desirable, it is imperative that individuals making gifts do not leave themselves short. In particular, potential care costs should be factored into a financial plan and estate planning strategy for more senior donors.
To discuss your tax and investment planning, request a call back.
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