Inheritance Tax
WHAT IS INHERITANCE TAX ?
Inheritance tax (IHT) is a tax on any transfer of assets to other people or trusts. It is usually paid in respect of an individual's estate on death, but it can also be applied in respect of certain transfers of assets during an individuals' lifetime. At present, IHT is payable at 40% on all of an individual's estate above a designated threshold - £325,000. You don't have to be overly affluent to achieve this threshold. Today, the value of your property can easily take you over the threshold.
When you die, the value of your estate is calculated based upon the total value of all your possessions and assets, less any available exemptions and relief. If the taxable estate exceeds the nil rate tax band of £325,000 (for 2024/25), anything over that sum is taxed at 40% (although lifetime transfers are more complex, charged at 20% with periodic charges at every ten years).
Since 2007 it has been possible for a spouse or civil partner to inherit their spouse's unused nil-rate band. Prior to this, each person's nil-rate band was treated in isolation, just like income tax allowances are. In most cases, all property and assets pass to the surviving spouse as an inter-spouse transfer (and therefore not taxable) it is possible to leave the entire nil-rate band to your spouse and double their exemption.
Please note that the Inheritance Tax Threshold has been frozen at the current level until the 2016/2017 tax year. This could affect any Inheritance Tax planning measures that people have already put in place.
From 6 April 2012, a new 36% rate has been introduced. This is only available if a charitable gift or legacy from the estate has been made. In order to qualify, the gift (or gifts) must be at least 10% of the net value of the estate after all reliefs and exemptions have been taken into account. This measure has been taken to encourage charitable giving and not penalise individuals for doing so.
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The value of estates above the threshold is taxed at 40%.
Chargeable Lifetime Transfers are taxed at the rate of 20%.
Residence Nil-Rate Band
From 6 April 2017 and additional nil-rate was introduced, where residential property is left to direct descendants.
Initially, it was set at £100,000 but increases by £25,000 each year until it reaches £175,000 in April 2020. Just like the standard nil rate band, a spouse or civil partner can inherit any unused Residential Nil-Rate Band.
However, there are conditions attached, so not everybody can take advantage of this allowance. The most important factor is there is a 'Qualifying Residential Interest' in the property. Factors used to determine this interest include:
Qualifying Residential Interest
- You need to have owned (or part-owned) a property that was your residence at some point during the period of ownership.
- This cannot be offset against second or buy-to-let properties. If more than one property is involved, you can only nominate one property.
- If you do not own the property you live in, or have sold a property in order to move into residential care, you cannot take advantage of the Residential Nil-Rate Band.
- If you have previously used equity release in conjunction with the property, any outstanding loan will be deducted from the value of the property, and a net value will be used.
- n order to pass on a qualifying residential interest, the property needs to be ‘closely inherited’. This means that the property must be passed to direct descendants. Direct descendants include children, grandchildren and any remoter descendants together with their spouses or civil partners. It also includes a step, adopted or fostered child or a child to which the deceased was appointed as a guardian or a special guardian when the child was under 18. All other relatives do not qualify.
Large Estates
- If your estate is valued at more than £2 million, the Residential Nil-Rate Band will be progressively reduced by £1 for every £2 that the value of the estate exceeds the threshold.
- In determining whether the £2 million threshold is breached, it is necessary to ignore reliefs and exemptions that apply to the standard Nil-Rate Band.
- This excludes any lifetime gifts, even if they were made within seven years of death and are included in the standard IHT calculation.
- The £2 million threshold is frozen until 5 April 2021, after which it will increase in line with CPI .
'Potentially Exempt' Charges on Gifts within seven years of death:
Years Before Death |
0-3 |
3-4 |
4-5 |
5-6 |
6-7 |
|---|---|---|---|---|---|
Tax Reduced By |
0% |
20% |
40% |
60% |
80% |
These gifts are known as Potentially Exempt Transfers (PETs) and should not be confused with Chargeable Lifetime Transfers. A Chargeable Lifetime Transfer is one that is not exempt and not potentially exempt. These mainly relate to lifetime transfers to discretionary trusts. If a Chargeable Lifetime Transfer takes the donor's seven-year cumulation over the nil-rate band, a tax charge will result at the lifetime rate of 20% on the amount over the nil-rate band.
MAIN POINTS ABOUT INHERITANCE TAX
IHT on lifetime gifts
Lifetime gifts fall into one of three categories:
- A transfer to a company or a discretionary trust is immediately chargeable
- Exempt gifts will be ignored both when they are made and also on the subsequent death of the donor
- Any other transfers will be potentially exempt transfers (PETs) and IHT is only due if the donor dies within seven years. It might therefore be more accurate to regard them as potentially chargeable transfers.
IHT on death
The main IHT charge is likely to arise on death. IHT is charged on the value of the estate. This includes any interests in trust property where the deceased had a right to income from, or use of, the property. Furthermore:
- PETs made within seven years become chargeable
- There may be an additional liability because of chargeable transfers made within the previous seven years.
Estate planning
A great deal of estate planning involves making lifetime transfers to utilise exemptions and reliefs, or to benefit from a lower rate of tax on chargeable lifetime transfers.
However, it can be the case the attempting to avoid one set of tax rules simply generates another liability under a different set of tax rules. For example a gift that saves IHT may unnecessarily create a capital gains tax (CGT) liability. However, the prospect of saving IHT should not be lead you into actions that you would avoid under normal circumstances.
Use of PETs
Wherever possible gifts should be made as PETs rather than as chargeable transfers. This is because the gift will be exempt from IHT if the donor survives for seven years.Nil rate band and seven year cumulation.
Chargeable transfers covered by the nil rate band can be made without incurring any IHT liability. Once seven years have elapsed a gift is no longer taken into account in determining IHT on subsequent transfers. Therefore every seven years a full nil rate band will be available to pass assets out of the estate.
EXEMPTIONS
Annual exemption
£3,000 per annum may be given by an individual without an IHT charge. An annual exemption may be carried forward to the next year but not thereafter.Gifts between husband and wife
Gifts between husband and wife are generally exempt. It may be desirable to use the spouse exemption to transfer assets to ensure that both spouses can make full use of lifetime exemptions, the nil rate band and PETs.
Small gifts
Gifts to individuals not exceeding £250 in total per tax year per recipient are exempt. The exemption cannot be used to cover part of a larger gift.
Gifts which are made out of income which are typical and habitual and do not result in a fall in the standard of living of the donor are exempt. Payments under deed of covenant and the payment of annual premiums on life insurance policies would usually fall within this exemption.
Family maintenance
A gift for family maintenance does not give rise to an IHT charge. This would include the transfer of property made on divorce under a court order, gifts for the education of children or maintenance of a dependent relative.Wedding presents
Gifts in consideration of marriage are exempt up to £5,000 if made by a parent with lower limits for other donors.
Gifts to charities
Gifts to registered charities are exempt provided that the gift becomes the property of the charity or is held for charitable purposes.
Business property relief. When ‘business property’ is transferred there is a percentage reduction in the value of the transfer. Often this provides full relief. In cases where full relief is available there is little incentive, from a tax point of view, to transfer such assets in lifetime. Additionally no CGT will be payable where the asset is included in the estate on death. However the reliefs may not be so generous in the future and therefore gifts now may be advisable.
FURTHER MITIGATING THE LIABILITY
Use of trusts
Trusts can provide an effective means of transferring assets out of an estate whilst still allowing flexibility in the choice of who benefits from the assets and/or permitting the donor to retain a degree of control over the assets. Provided that the donor does not obtain any benefit or enjoyment from the trust, the property is removed from the estate. However, recent moves by the treasury (especially since the 2006 budget) aim to restrict the use of trusts in inheritance tax planning, and inheritance tax planning in general. Trusts such as Accumulation & Maintainence Trusts and Interest in Possession Trusts will face lifetime IHT charges upon assets passing into these trusts and ten yearly charges, like those suffered by Discretionary Trusts. Therefore, now more than ever, if you are considering using trusts as an IHT mitigation tactic, then specialist tax planning advice is essential.
Life assurance
Life assurance arrangements can be used as a means of removing value from an estate and also as a method of funding IHT liabilities. A policy can also be arranged to cover IHT due on death. It is particularly useful in providing funds to meet an IHT liability where the assets are not easily realised, eg family company shares.
As the main IHT liability is likely to arise on death, a sensible and up to date Will is important. IHT may arise when a person dies or on certain lifetime gifts which are not exempt or potentially exempt.
- Individuals domiciled in the UK may be subject to IHT on their worldwide assets.
- Non-UK domiciled individuals are generally only subject to IHT on their UK assets.
- Individuals who have been resident in the UK in 17 out of the previous 20 years are treated as UK domiciled for IHT purposes.
Husbands and wives are taxed separately; however, there is no IHT on transfers between spouses, provided the recipient is domiciled in the UK.
This is only a quick introduction to what can be a complex subject. If you think that you could be liable to a IHT charge, then we recommend that you seek professional financial or tax advice.
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