The general perception of Inheritance Tax (IHT) is that it is a death tax and therefore should only be given due consideration when thinking about your will and how to distribute your assets when you die. Although this is true, there are other occasions during your lifetime where you need to consider the IHT implications on your assets, for example making gifts during your and also making gifts within 7 years of death.
When considering your IHT position therefore involves a review of your actions whilst alive through various gifting you may do to loved ones to help reduce your estates value, before considering the final IHT due on death.
IHT is a controversial tax which many people believe is unfair as taxation occurs on assets throughout your life, so why again on death? Despite this, there is no way of getting out of paying IHT but the rules around IHT are currently under scrutiny by the Office of Tax Simplification, who have suggested reforms which the government can decide whether to implement or not consider.
Here, we look at the fundamental rules of IHT currently in place and how this affects and individuals wealth.
Who is liable for IHT?
An individual who is UK domiciled is liable for IHT on their worldwide assets, whereas non-UK domiciled individuals are liable for IHT on their UK assets only.
What are lifetime gifts?
Lifetime gifts are gifts made on your estate whilst you are still living and are split into two categories – Potentially Exempt Transfers or PETs, where an individual gifts another another individual, and Chargeable Lifetime Transfers or CLTs, where a gift of capital is made by an individual to a trust.
A PET is not subject to any tax charge when the gift is made unless the donor (the individual gifting) dies within 7 years of gifting. This is known as a failed PET and a tax charge will be due at the time of death.
A CLT on the other hand is chargeable to the donor at the time the gift is made, and if the donor dies within 7 years of gifting, there is an additional tax at the point of death.
Exemptions
There are certain exemptions which apply for both PETs and CLTs. Examples of exemptions include small gifts exemptions, gifts in consideration of marriage, normal expenditure out of income and the annual exemption.
The good news is that any gifts made to a spouse or registered civil partner on death is always exempt from IHT. Furthermore, if one person in a couple dies, the surviving person can make use of their partner’s Nil Rate Band (NRB), which is a level of IHT tax exemption available to all individuals, and the value dependent on the rate at the year of death.
The small gifts exemption means that any gifts made below £250 per annum during your lifetime is exempt also. However, if the amount is £250 or above, the entire gift is chargeable. So this doesn’t make the first £250 of every transfer exempt, rather a small gift is looked at isolation. In the Office of Simplification suggestion of changes to rules just published, they recommend this amount be increased to under £1,000, but this will require review and sign off by government.
The gifts in consideration of marriage is relevant when the donee (the person receiving the gift) is getting married. The nature of the relationship of the donor to the donee determines the level of exemption allowed. If the donor is a parent, the level of exemption is £5,000 and if the donor is a grandparent, the exemption is set at £2,500. If the gift is from one marriage party to another, the level of exemption is also set at £2,500. A gift from anybody else relating to marriage is set at £1,000.
If the gift in consideration of marriage is more than the maximum amount of exemption, unlike the small gifts exemption, the maximum amount of exemption can be used and any remaining gift amount is liable to IHT only.
The normal expenditure out of income relates to gifts made for regular use and has no transfer value, and highlights that IHT relates to capital assets not regular income. To demonstrate that a gift is going towards normal expenditure to someone during your lifetime, there are two key factors for the gift to be exempt from IHT. These are that the donor’s standard of living is not affected and the gift should be regular or habitual in nature. For example, a grandparent paying for school fees on a regular basis from their surplus income would be considered normal expenditure out of income. However, if the payments are made from the grandparent’s savings, this could be liable for IHT.
The IHT allowance for all individuals is £3,000 per tax year. However, there is an unusual rule that sets it apart from the capital annual exemption.
When an individual makes a lifetime transfer, they need to make use of their annual exemption amount first for the same tax year, as well having the option to use unused their previous year’s annual exemption if applicable.
PETs are not charged IHT tax during your lifetime as noted above but they do use up your annual exemption, so care must be taken when making PETs.
In our next blog, we will look at the advantages of lifetime giving and how Inheritance Tax is paid.
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Written by Shaima Todd.
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