Inheritance tax – lifetime gifting
Death duties have been with us for centuries, in the guise of Estate Duty, Capital Transfer Tax and now Inheritance Tax (IHT). The combination of frozen thresholds and rising property prices have meant more estates than ever are likely to face an IHT bill.
This briefing provides an overview on how gifts can be made during lifetime; the criteria that needs to be followed to be effective and the order in which gifts should be made. Supporting calculations are included to show the learning points in practice.
IHT is a tax on the transfer of assets on certain lifetime gifts or on death. Most assets will be chargeable to IHT unless they are specifically exempt.
- IHT is only charged on the part of an estate that is the above the tax-free allowance (called the Nil Rate Band) of £325,000. There is also a Main Residence Nil Rate Band of £175,000 which is available to anyone who owns a main residence which is passed onto their direct descendants.
- There are various ways to mitigate IHT, including reducing the size of an estate whilst alive by making gifts. However, to have this effect, gifts need to comply with certain criteria.
- There are two types of gifts or transfers that can be made during lifetime: Chargeable Lifetime Transfers or Potentially Exempt Transfers.
- The rate of IHT reduces if gifts are made and the individual making the gift survives between three and seven years – this is known as Taper Relief.
- No IHT is payable on gifts between spouses/civil partners as long as both parties are domiciled in the UK.
Gifts with reservation of benefit
Potentially Exempt Transfers (PET)
Chargeable Lifetime Transfers (CLT)
How PETs and CLTs interact with each other – the order of gifting
Inheritance Tax (IHT) is a tax on the transfer of assets on certain lifetime gifts or on death. This is normally any gift made by someone that results in them suffering a decrease in the value of their estate. The measure of a gift for IHT purposes is always the loss to the donor’s estate and not the amount gained by the recipient.
For gifts made during lifetime, generally once the individual survives seven years after having made the gift, the value will not be counted as part of their estate on death and will be exempt from IHT. The two main lifetime gifts are; Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs).
In some cases, it may be necessary to look back 14 years from the date of death, depending on multiple gifts that have been made and if they were a mixture of PET’s and CLT’s.
The primary determinant of an individual’s liability to IHT is the individual’s domicile. For those domiciled in the UK, IHT applies to all worldwide assets. For those domiciled abroad (non-UK domiciles), the tax usually applies only to assets situated in the UK.
Some gifts are completely exempt from IHT whether they are made during lifetime or on death and others are exempt only if made during lifetime. The person making the gift is the donor or transferor and the recipient is the donee or transferee.
There can be benefits to gifting money and property to others during an individual’s lifetime. Gifting can reduce IHT, however, to have this effect, gifts need to comply with certain criteria.
Any gift that is exempt from IHT will not be included in the calculations when working out whether any IHT is due.
Gift with Reservation of Benefit
An individual must have given up all rights to the asset otherwise it will be classed as a Gift with Reservation of Benefit. If at the time of the transferor’s death, a gift is subject to a reservation of benefit, the value of that gift will be treated as part of their estate for IHT purposes. It will be treated as if the gift was never made, notwithstanding the legal ownership may have passed from the deceased to the recipient of the gift, during their lifetime.
For example, if an individual gives their house to their children, but the individual continues to live in it rent-free, the house will still be considered as part of their estate and IHT may be payable upon death.
Potentially Exempt Transfers (PET)
A PET is where a gift has been made from one individual to another. An everyday example is where a parent makes a cash gift to a child (that is not otherwise exempt). Once made the gift will form part of the beneficiary’s estate for IHT purposes on death, bankruptcy and divorce.
When PETS are made, the individual must survive for seven years after making the gift for it to be exempt. So, if the individual survives for seven years, the PET escapes IHT altogether and will never be brought into the IHT calculation. The seven year rule doesn’t apply to gifts where the individual has reserved a benefit.
A PET is only potentially exempt, so if the individual dies within seven years of having made the gift, it fails and becomes chargeable, known as a Chargeable Transfer (CT) for IHT purposes. This means that it will be included in the individual’s IHT calculation.
Taper Relief can reduce the amount of tax to pay if the cumulative value of any gifts made within the seven years prior to death exceeds the IHT allowance of £325,000. IHT is payable at the following rates on any gifts given in excess of this during the seven years before death, as follows:
|Less than 3 years
|100% of the IHT payable on the gifts
|80% of the IHT payable on the gifts
|60% of the IHT payable on the gifts
|40% of the IHT payable on the gifts
|20% of the IHT payable on the gifts
Chargeable Lifetime Transfers (CLTs)
Gifts such as transfers into discretionary trusts are CLT‘s. The individual who gifts assets into the trust is called the Settlor or Donor.
A CLT is a gift made during a settlor’s lifetime which is immediately chargeable to IHT. This does not necessarily mean that there will be IHT to pay but it does have to be assessed to see if a charge to IHT will arise. Each individual can gift up to £325,000 in a seven-year rolling period before an entry charge applies.
CLTs are cumulative and CLTs made in the previous seven years prior to the current CLT will reduce the amount of nil rate band available.
- If the sum of CLTs in the seven period is below the nil rate band, there will be no IHT due immediately.
- If the sum of CLTs in the seven-year period exceeds the nil rate band, then there will be a charge to IHT on the excess, known as ‘an Entry Charge’. The charge is at the lifetime rate of 20%, which is half of the death rate.
The liability to IHT on the CLT rests with the settlor, although the settlor and trustees can agree between them as to who pays. The amount of the transfer must be grossed up if the settlor pays the tax, as this is regarded as a further gift and is a transfer of value. The tax must be grossed-up to value the loss to their estate. This gives an effective rate of 25%.
With CLTs, because the trust assets are not included in the taxable estate of any of the beneficiaries, the trust itself will be assessed to IHT every 10 years. This is known as the periodic charge. In addition, an IHT exit charge is calculated when capital (not income) is distributed to a beneficiary.
If the donor survives for seven years from the date of gift, there will be no further IHT payable, however, there is no refund of any IHT paid during life.
If an individual dies within seven years of making a CLT, it will be brought into the IHT calculation and tax will be recalculated at the full death rate (40%). As with PETs, taper relief can reduce the amount of IHT payable on death, if the settlor dies within 7 years of making a CLT.
How PETs and CLTs interact with each other – the order of gifting
Before making a lifetime gift, it is important to understand an individual’s gifting history. Gifts made in the previous seven years may affect the IHT payable on the current gift and, if the gift is made into trust, future IHT charges may apply, so making gifts in a specific order is important.
Two main considerations when planning the IHT position of gifts are the tax position whilst the individual is alive and the tax position after the individual has died.
For gifts made at the same time, usual planning would be to consider making CLTs before PETs. In this way there is no risk of a failed PET reducing the nil rate band available throughout the lifetime of the trust created by the CLT.
PETs before CLTs
There are two issues to consider: the entry charge on lifetime gifts into trust and the impact of death.
A CLT will be subject to an immediate charge to IHT at 20% where the value of the CLT, when added to any other CLTs made by the settlor in the preceding seven years, exceeds the IHT nil rate band. PETs can therefore be ignored in this accumulation at this point.
However, if in a seven-year period, an individual makes a PET, then a CLT and subsequently dies, the PET will become a chargeable transfer or ‘failed PET’. Both the failed PET and the CLT will be included in the IHT calculation of the individual.
In addition, if a PET has been made in the seven years leading up to the discretionary trust creation (which was a CLT), and subsequently fails becoming chargeable, this causes an impact to the trust when assessing for future periodic charges. This is because chargeable transfers in the seven years prior to the trust creation are added into the periodic charge computation.
CLTs before PETs
Again, there are two issues to consider – lifetime gifts and the impact of death.
During lifetime, CLTs have no impact on PETs as they do not become chargeable unless the individual dies within seven years of making the PET. However, when calculating the IHT payable by the estate, failed PETs and CLTs made in the seven years before death are included.
If a PET is created after the set-up of a discretionary trust, this can expand the timeline for the CLT beyond the seven years and can potentially keep the CLT in the timeline for up to 14 years. Under the complex IHT rules, it states that if a PET fails and becomes chargeable from the date of that gift, you look back seven years and include any previous CLTs.
There are implications either way when looking at the order of gifting. Considerations include:
- The value of gifts.
- The type of gift.
- Succession of gifts and the order in which they are made.
- The position if the donor dies within seven years of making the gift.
An individual should always utilise any exemptions, reliefs and allowances and then usual planning would be to consider making CLTs before PETs. In this way there is no risk of a failed PET reducing the nil rate band available throughout the lifetime of the trust created by the CLT.