A couple have received conflicting advice about reducing their potential inheritance tax (IHT) liability by making gifts. One view is that they need to survive at least three years from when a gift is made to save IHT. The other advice says they must survive seven. Which view is correct? Kenny Logan from our Edinburgh office looks at this in more detail below.
The inheritance tax (IHT) rules for gifts made during a person’s lifetime are tricky. In the case above, the seemingly conflicting advice is correct in both instances. There can be an IHT saving if you survive at least three years after making a gift, but you might also have to survive at least seven years. Which of these statements applies depends on the value of the gift.
The three and seven year rules
If a person survives at least seven years from the date of a gift to an individual, it’s called a potentially exempt transfer (PET) and is ignored for IHT purposes when they die. But if they don’t survive that long the value of the gift is taken into account when working out the IHT on their estate. However, any IHT that becomes payable on the gift is reduced as follows:
Mary dies in December 2022. Just over five years earlier she made gifts to her family. The gifts were PETs but became chargeable to IHT because she didn’t survive seven years. Because she survived between five and six years after making the gifts, the full IHT rate is reduced to 40% of its normal rate, i.e. 16% (40% IHT x 40% tapering).
Taper relief only reduces IHT where it’s payable on the value of the gift (PET) itself. Broadly, if the value of a gift is less than the IHT nil rate band there’s no IHT payable on it even if it forms part of the estate for calculating the tax payable.
When a person dies the IHT on PETs which become chargeable (known as failed PETs) is calculated before the IHT on the rest of estate. This means the IHT nil rate band (NRB) (the part of the estate taxable at 0%) applies to the failed PET first. So, unless the total value of all failed PETs within the seven years before death exceeds the NRB (including any NRB transferred from the deceased’s spouse or civil partner), there’s no IHT payable on the PETs and so nothing to taper. Nonetheless, the failed PETs have resulted in extra IHT on the estate.
Nearly seven years ago John’s father’s estate was worth £900,000. In an attempt to reduce the IHT he made a gift of £250,000 to John. Unfortunately, his father dies before seven years had elapsed. The gift is a failed PET and so treated as the first part of the father’s estate. It therefore uses £250,000 of the estate’s NRB. Zero tax is payable on the value of the gift, so no tapering relief is due, but the NRB is reduced by £250,000 meaning there’s less to use against the remainder of the estate. This in turn increases the IHT on the estate by £100,000 (£250,000 x 40%).
Insurance companies sell policies specifically to cover IHT bills resulting from failed PETs. They can be costly but overall cheaper than the tax on a failed PET and so are worth consideration.
An alternative to an insurance product, a discounted gift scheme, is also worth considering. It can remove some of the value of a gift from your estate with less risk than a PET.
Both views are correct, but only tell half the story. The three-year rule reduces, but does not eliminate IHT on lifetime gifts to the extent they exceed the amount of the nil rate band. To eliminate IHT entirely seven years must elapse from the date of the gift.
If you are considering gifting assets out of your estate do get in touch with JRW to fully discuss the implications relating to your personal tax affairs.