Few people appreciate that inheritance tax is not just a death tax – it can be due on lifetime transfers too!
Where a lifetime chargeable transfer is made – that is, a transfer for which inheritance tax is due – the rates are as follows:
- 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
Note that the above rates only apply where inheritance tax is immediately due.
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 the higher death rates e.g usually 40% (although if within 3 and 7 years, the rate is tapered).
If the gift involves the creation of a trust (settlement), since 22nd March 2006, inheritance tax is immediately payable at the above rates. 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. Credit is given for the tax paid when the settlement was created.
When looking at lifetime transfers for the purpose of inheritance tax, the nil rate band (inheritance tax threshold) applies – however, a spouse or civil partner does not get the percentage uplift if their spouse/civil partner has died without using the whole of their allowance. Of course, when the survivor dies, that additional uplift may be available.
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, 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 for example, if A gifts £325,000, survives for 5.5 years and then dies, leaving an estate of £100,000 (and assuming the RNRB 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 gift fell within the nil rate band. If however A gifted £425,000 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
Where a gift is made into a settlement, this is immediately chargeable at lifetime rates. 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 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.
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.
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