Inheritance tax on ‘Lifetime Chargeable Transfers’

Few people appreciate that Inheritance Tax is not just a death tax – it can be due on lifetime transfers too!

We use the word transfer here to mean a gift of property from yourself to someone else.

Many transfers are known as ‘Potentially Exempt Transfers’ – PETs – because Inheritance Tax will only be payable if the person making the gift dies within 7 years. When the gift is made, no Inheritance Tax is payable. If the person survives for 7 years, the gift is disregarded for Inheritance Tax purposes. If however the person dies within 7 years, Inheritance Tax is payable on the gift and this will be at “death rates” e.g usually 40% (although if within 3 and 7 years, the rate is tapered).

The above does not apply where the gift comes under one of the person’s annual gifting allowances (read more about inheritance tax on gifts here).

Note that if the person gifts property but continues to enjoy a benefit from it, it may be included in the value of their estate for Inheritance Tax purposes, despite the fact that they no longer own it. It may also be regarded by the Local Authority as a ‘Deprivation of Assets’ for care fee purposes. Find out more about gifts with a reservation of benefit and deprivation of assets, or read our article, ‘Should I give away my home to my child?‘.

If the gift involves the creation of a trust (a “settlement”), since 22nd March 2006, Inheritance Tax is immediately payable at the rates below.

  • 0% – first £325,000 (the nil rate band or inheritance tax threshold) – however, this may be reduced by the value of any chargeable transfers made in the 7 years prior to the current transfer being considered.
  • 20% on the balance

If, then, the “settlor” (that is, the person making the trust) dies within 7 years, Inheritance Tax is reassessed on the gift at the higher death rates (40%). Credit is given for the tax paid when the settlement was created.

However, there are some quite generous allowances that can be used here – for example, you can gift out of your surplus income provided that it does not affect your standard of living.

Note that whilst those with a spouse or civil partner get a percentage uplift on their nil rate band (their standard Inheritance Tax allowance) if their spouse/civil partner dies without using the whole of their allowance, this can’t be used when looking at Inheritance Tax on Lifetime Chargeable Transfers. Of course, when the survivor dies, that additional uplift may be available if needed.

Tapering relief

Where the person making the gift dies more than three years after the date that the gift was made, the usual 40% death rate is reduced depending on how soon they died after making the gift. The rates are as follows (Section 7(4) Inheritance Tax Act 1984):

  • Gift was made 3 – 4 years before death : 80% of death charge
  • Gift was made 4 – 5 years before death : 60% of death charge
  • Gift was made 5 – 6 years before death : 40% of death charge
  • Gift was made 6 – 7 years before death : 20% of death charge

If however the gift was within the Nil Rate Band (i.e. your standard Inheritance Tax allowance), the tapering relief is irrelevant. This is because the tapering relief is intended to reduce the tax paid and if the gift fell within the nil rate band, no tax would be paid. This sounds rather obvious at first glance but consider this example:

If A gifts £325,000 to B, survives for 5.5 years and then dies, leaving an estate of £100,000 (and assuming the additional Residence Nil Rate Band does not apply), he has used his entire nil rate band on the lifetime gift and therefore, £40,000 inheritance tax will be payable. There’s no credit here for the fact that A survived for 5.5 years after making the gift because the lifetime gift fell within the nil rate band.

If however A gifted £425,000 to B and survived for 5 years, leaving an estate of nil, only £16,000 of inheritance tax would be payable. When A made the gift, it was a PET – a potentially exempt transfer – so no tax was payable at the time. When A died, Inheritance Tax becomes payable at death rates. No tax is payable on the first £325,000. Tax is payable at 40% on the next £100,000 but as A died between 5 – 6 years after making the gift, only 40% of this is payable = £16,000. Note that there are annual exemptions which could reduce this bill further if not already used.

Transfers to trusts

As noted above, where a gift is made into a trust (settlement), this is immediately chargeable at lifetime rates, subject to any Nil Rate Band that may be available. So what happens if a person then dies within 7 years of making the gift? The tax is recalculated at death rates.

For example:

A transfers £355,000 into a discretionary trust. £325,000 is covered by his nil rate band, with £30,000 over. Inheritance tax is due at the time of making the transfer, calculated at 20% of £30,000 = £6,000.

A then dies within a year. The tax is reassessed at death rates which are 40% of the amount over the nil rate band – i.e. £12,000. Credit is given for tax already paid.

Note that if A had a Deceased spouse who did not use any of her nil rate band, his estate would benefit from a 100% uplift on A’s death. If this meant that no inheritance tax was payable on the gift, there is no refund of the tax already paid.

The above is intended to be a general overview of Inheritance Tax on Lifetime Chargeable Transfers and not a substitute for professional advice on your individual circumstances.

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