This article outlines why it is important for an adviser to establish the full gifting history of a settlor who makes gifts into discretionary trusts for inheritance tax purposes.
There are three main types of gift for inheritance tax (IHT) purposes. Those that are exempt, those that are potentially exempt (potentially exempt transfer or PET) and chargeable lifetime transfers (CLT).
CLTs are chargeable to a maximum of half the death rate (ie 20%) when the value is transferred. Where the settlor dies within seven years, additional IHT may be due.
PETs are not subject to IHT at the time of the transfer of value, but will become chargeable if the settlor dies within seven years of making the transfer.
Exempt transfers are immediately exempt and are not subject to the seven-year PET rule or ‘entry charge’ of 20% as with CLTs.
When creating PETs and CLTs as part of any IHT planning exercise with a clean gifts history, creating PETs before CLTs will usually help to minimise any possible future IHT tax.
However, if multiple gifts have been made over time, when calculating what nil-rate band (NRB) is available on death, and whether additional tax is due on previous ‘gifts’, the calculation can require information from as far as 14 years previously, not seven years.
Example where no previous gifts have been made
John Jones died 1 January 2013, He has an estate of £525,000 and has made no previous gifts (other than using his annual exemption). The IHT liability (assuming annual exemptions already used):
£525,000 - £325,000 NRB = £200,000 x 40% = £80,000 tax
Example where previous gifts have been made
Dawn Brown also died on 1 January 2013. She also has an estate of £525,000, but she has made two previous gifts. A CLT of £150,000 on 3 January 1999 and a PET of £213,000 on 2 January 2006.
The PET would fail as seven years has not elapsed between the transfer and Dawn’s death. To calculate whether there is any additional IHT tax to pay on the failed gift we need to consider any other failed PETs (none in this case) or CLTs if within seven years of the PET. As the CLT was made within seven years of the failed PET. The CLT of £150,000 would be added to the failed PET (£213,000) to see if additional tax was due. Tax is due on the PET as explained below.
Tax due on the PET:
£150,000 + £213,000 – £325,000 (NRB at death) = £38,000.
£38,000 x 40% = £15,200.
As the failed PET was made between six and seven years prior to death, taper relief would be available reducing the tax due:
£15,200 x 20% = £3,040.
This would be paid by the recipient of the PET.
For clarity, PETs which have been made more than seven years before death would be exempt so would not be added into any calculation.
Tax due on Dawn's estate:
The estate’s NRB will be reduced by the failed PET.
NRB £325,000 - £213,000 = £112,000.
£525,000 - £112,000 = £413,000.
£413,000 x 40% = £165,200.
For clarity, the estate’s NRB will not be reduced by the CLT because it was made more than seven years prior to death.
If the PET had been on 4 January 2006 it would still fail, but the CLT would be outside the accumulation period and there would have been no additional tax on the PET, a saving of £3,040.
The need to consider previous transfers should not deter individuals from making gifts, but where there are multiple gifts over an extended period, identifying the possibility of unexpected tax on the gifts as well as a reduction of the available nil-rate band is important should death occur within seven years.