Lifetime IHT Planning: Transfers and Tax

16 September 2021

The Brand Financial Training team examine IHT planning, in respect of lifetime transfers of wealth and how the tax rules apply.

Lifetime transfers fall into the following four categories:

  • Exempt from IHT
  • Potentially Exempt
  • Chargeable but not taxable
  • Chargeable and taxable

An exempt transfer is one that is not liable to IHT and not counted in the cumulation for the future.

The main exemptions are:

  • The spouse/civil partner exemption – married couples and civil partners that are UK domiciled can pass all of their estate to each other free of IHT with no limit
  • Gifts within the annual exemption of £3,000 per tax year – the unused balance from one tax year can be carried forward to the next (note this only applies to lifetime transfers and not to transfers on death)
  • The small gifts exemption of up to £250 to as many people as the donor wishes (although not to the same person who has already received the £3,000 annual exemption)
  • Normal expenditure out of income – regular gifts that leave the transferor with sufficient income to maintain their normal standard of living
  • Gifts on marriage within specified limits – £5,000 to children, £2,500 to grandchildren, £1,000 to anyone
  • Gifts to charities or political parties – tax free during lifetime and on death (and a reduced IHT rate of 36% where at least 10% of the net estate is left to charity)
  • Gifts for the national benefit for example, to museums, libraries etc.
  • Estates of members of the armed forces whose death can be attributed to injury or illness suffered whilst on active service
  • Estates of members of the emergency services and humanitarian aid workers responding to emergency circumstances

A potentially exempt transfer (PET) is one that is not liable to IHT at the time of the gift but is counted in the cumulation for the future and is a favourite topic to be tested within the R03 and AF1 exams. These are gifts, not covered by exemptions, by individuals to:

  • Other individuals
  • Bare trusts
  • Disabled trusts
  • Interest in possession trusts set up prior to 22 March 2006

If the transferor dies within 7 years of making the gift, the transfer becomes chargeable with taper relief available on any tax where death occurs within 3 – 7 years, as below:

  • Between 3 and 4 years – 20% reduction
  • Between 4 and 5 years – 40% reduction
  • Between 5 and 6 years – 60% reduction
  • Between 6 and 7 years – 80% reduction

Note that taper relief only applies to the tax originally due on the gift (not to the value of the gift) so therefore any gifts that fall within the nil rate band (NRB) are taxed at zero and therefore taper relief cannot apply.  Any IHT is payable by the recipient (the donee).

Chargeable lifetime transfers are those which are neither exempt nor potentially exempt – the most common are gifts to trusts which are neither bare trusts nor for disabled beneficiaries.

If such gifts are made within the NRB, then they are chargeable, although no IHT is payable at the time of the gifts. They would however be taken into account on the donor’s death within 7 years and would mean less of the NRB available to set against the death estate.

Complications arise when PETs are also made and subsequently become retrospectively chargeable on death, increasing the cumulation to take it over the NRB.

Chargeable lifetime transfers in excess of the NRB will result in a tax charge of the lifetime rate of 20% of the excess, with no further IHT to pay if the donor survives seven years.  The IHT on a CLT can be paid by the trustees but if paid by the settlor then the transfer will need to be grossed up.

If the donor doesn’t survive seven years, then the death rate (40%) will apply retrospectively, with relief given for the lifetime tax paid.

Typical AF1 question

Let’s look at what could be a very typical question found within the AF1 exam:

Kate has made the following gifts:

No other gifts have been made in Kate’s lifetime and she dies in October 2021, leaving an estate of £525,000 to her son, including the family home worth £450,000. Her husband pre-deceased her, leaving the full value of his NRB to their son in cash. The remainder of his estate went to Kate.

The question is, calculate, showing all your workings, Kate’s IHT liability.

The first thing to note is that the gift made in 2018 to her son is a PET.  As we are told that Kate has not made any other gifts, we can straight away deduct two annual exemptions.

  • Gift in 2018 to her son = PET
  • Use current and previous year’s annual exemption – total £6,000
  • PET is £290,000 – £6,000 = £284,000

The gift into the discretionary trust in 2019 is a chargeable lifetime transfer (CLT).

CLTs result in an immediate IHT charge if they, along with the previous 7 years’ cumulative total of CLTs, exceed the available NRB.  This CLT is within the NRB and therefore there is no immediate IHT liability.  (Note that although a PET was made within the 7-year period before the gift into the discretionary trust was made, it is ignored for the purposes of assessing whether any IHT is due in respect of the CLT).

  • Gift in 2019 to discretionary trust = CLT of £68,000

On Kate’s death in October 2021:

Lifetime transfers

Transfers made in the 7 years before death are used against the NRB in the order in which they are made:

  • The PET was made 3 – 4 years before death
  • The PET of £284,000 was within the NRB and so is not liable for tax
  • However it does reduce the available NRB by £284,000, leaving £41,000
  • The CLT to the discretionary trust is within 3 years of death, so tax at the death rate applies
  • Taper relief potentially applies but because the transfer was made between 2-3 years before death, the tax due remains at 100% of the calculated figure
  • Amount chargeable to IHT = £68,000 – £41,000 = £27,000 @40% = £10,800

Balance of estate

  • £525,000 – £350,000 (2 x £175,000 Residence NRBs) = £175,000 @ 40% = £70,000

The final IHT liability is the total of the amount due on the estate on death plus the tax on the CLT.

Remember that the legal personal representatives will be liable for the IHT on the estate, whereas the trustees of the discretionary trust will be liable for the IHT on the CLT.

This article was first published in the September 2021 issue of Professional Paraplanner.

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