David Downie, Technical Consultancy Manager at Aberdeen Adviser, explains how the often-overlooked 14-year rule can influence the inheritance tax treatment of gifts and why careful planning is essential.
When it comes to lifetime gifting, timing really is everything. Gifts fall outside the estate after seven years. However, a gift into trust made up to 14 years ago could still affect the IHT payable on later gifts.
If a client dies within seven years of a gift, the tax on that gift takes account of any chargeable transfers made in the seven years before it.
Pensions enter the IHT net from April 2027, and more clients are looking at lifetime gifting. Understanding this rule could be the difference between a tax-free gift and an unexpected IHT bill for beneficiaries.
Lifetime gifting
Gifts made during lifetime fall into three types: exempt, chargeable lifetime transfers (CLTs) and potentially exempt transfers (PETs).
When gifting consists of only making CLTs into discretionary trusts, most clients will want to keep the seven-year cumulative value of CLTs to below the nil rate band. If they exceed the nil rate band, there will be an immediate lifetime charge on the excess of 20%.
However, if a client wishes to gift more than the nil rate band, they may consider making direct gifts which qualify as PETs.
These will never attract a tax charge during the donor’s lifetime and will be exempt once the donor has survived seven years. If the donor dies within seven years, the PET becomes chargeable and this may impact on IHT payable. But how?
Calculating the IHT
Essentially, there are two calculations on death – one for the tax on the estate itself, and the other on each ‘failed’ gift made in the last seven years.
Tax on the estate
The tax on the estate is broadly the value of the estate less any available nil rate band. This includes the residence nil rate band and any transferable residence nil rate band and nil rate band from a deceased spouse or civil partner.
The available nil rate band will be reduced by all the chargeable transfers, including PETs that become chargeable, made in the seven years before death. Any gifts older than seven years can be ignored – the ’14-year rule’ does not apply here.
Tax on lifetime transfers
We must also revisit each lifetime transfer in turn for the seven years prior to death, including PETs that have now become chargeable, to see what tax would have been paid at the time they were made.
This could pick up chargeable transfers in the seven years prior to the transfer in question. This is where the ’14-year rule’ originates. Chargeable transfers made up to 14 years before death can still influence IHT payable.
Each transfer is looked at in isolation and a separate calculation performed, using the current nil rate band and any available transferable nil rate band each time. However, the residence nil rate band cannot be used with lifetime transfers.
Taper relief may reduce the final amount of tax paid on lifetime transfers made more than three years before death. Remember that if the cumulative value of the transfers is within the available nil rate band, then there will be no tax on the transfer in question.
Example
Graham is a divorcee and parent of two children, Sarah and Tom, and grandfather to five grandchildren.
His gifting history, starting with the earliest year first, is as follows:
Year 1 – £300,000 into a discretionary trust (CLT)
Year 4 – £100,000 gift to Sarah (PET)
Year 7 – £50,000 gift to Tom (PET)
Year 9 – £75,000 into a discretionary trust (CLT)
Year 13 – Graham dies with an estate of £800,000 (including family home valued at £400,000).
The whole estate is to be split between his two children.
(Assume the gifts are made on the same date each year and the £3,000 annual exemption is already used.)
IHT on the estate:
We are only concerned with the estate owned by Graham on death and transfers made in the seven years before death. All other transfers can be ignored. This picks up the transfers in year 9 (£75,000 CLT) and year 7 (£50,000 PET to Tom).
Graham is entitled to a nil rate band of £325,000 and the residence nil rate band of £175,000. However, his standard nil rate band of £325,000 is used by the two lifetime transfers first, with any balance available to the estate.
As the total of lifetime transfers is £125,000, there will be no IHT on these, leaving £200,000 of nil rate band available to the estate. Note: lifetime transfers do not reduce any residence nil rate band.
The tax on the estate is (£800,000 – £200,000 – £175,000) x 40% = £170,000.
IHT on the failed lifetime transfers:
We must also look back to reassess what tax would have been paid on each chargeable transfer in the seven years before death. A new calculation is done on each transfer to work out what tax would have been paid at the time the gift was made but using the full current nil rate band and the IHT death rate (i.e. 40%).
Therefore, the transfers in scope are the year 7 gift to Tom and the year 9 gift into discretionary trust.
The transfers made in years 1 and 4 do not need to be revisited because they were made more than seven years before death.
Tax on year 7 gift to Tom
We must include any chargeable transfers in the seven years prior to the gift to calculate the tax due. This will pick up the £300,000 CLT made in year 1 but not the PET made to Sarah in year 4. This has become exempt because it was made more than seven years before Graham’s death.
The total £350,000 (£50,000 + £300,000) exceeds the current nil rate band by £25,000. This means there will be an IHT liability of £10,000 (£25,000 x 40%).
This is further reduced by taper relief. As Graham died between six and seven years from the date of the gift to Tom, only 20% of the IHT due will be payable, leaving a tax bill of £2,000 for Tom to pay.
Tax on year 9 gift to discretionary trust
Next, we need to reassess the £75,000 CLT made in year 9. Looking back seven years, we only need to bring in the year 7 gift (the failed PET to Tom). The earlier year 4 PET to Sarah is now exempt, and the year 1 CLT was made more than seven years before the year 9 gift.
The total of the year 7 and year 9 gifts is £125,000 – well under the nil rate band of £325,000. Therefore, the trustees of the discretionary trust have no further tax to pay on the year 9 CLT.
Analysis
The total IHT payable is £172,000 (£170,000 plus £2,000).
Had the gift to Tom in year 7 been limited to £25,000, there would have been no tax on it, but then there would have been an extra £25,000 in the estate. Ignoring growth, this would have resulted in £10,000 additional tax.
However, if the gift to Tom had been delayed by a year, it could have avoided tax altogether by ensuring there were more than seven years between the gift to Tom and the original £300,000 gift into trust.
Of course, this must be balanced against the likelihood of the client surviving their gifts by seven years – the earlier a gift is made, the sooner it will be outside the estate altogether.
Things to consider
Returning to the example, what if Graham had been widowed several years ago? If none of his late wife’s nil rate band had been used on her death, it would be available to Graham when calculating the IHT on his estate and when revisiting each of the lifetime transfers.
There would have been no tax on the estate as the total nil rate band (including the residence nil rate band) is £1,000,000 compared to the estate value (including lifetime gifts) of £925,000.
With regard to IHT on the two lifetime gifts in years 7 and 9, a nil rate band of £650,000 (do not include the residence nil rate band here) would have been available for each retrospective calculation, and so there would have been no further tax on these either. In fact, this time there would have been scope to make a larger gift to Tom.
Bringing it all together
The 14-year rule shouldn’t automatically put clients off further gifting, but it does need careful assessment.
The right timing and value of a gift will depend on the client’s gifting history, health, chances of surviving seven years, taper relief and available nil rate bands. Running the numbers for each client’s circumstances is key to getting a tax-efficient and suitable outcome.
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