Neil Da Costa explains lifetime gifts and IHT – this is stuff tax students really ought to know.
In this article I am going to show you how to ‘keep it simple’. Having been an Advanced Tax lecturer for more than 20 years I am fully aware of which areas examiners say that students struggle with.
These areas feature regularly in the tax exams, and by ensuring you understand them you can be confident of earning these marks in the question. In this article I will be showing you how to treat lifetime gifts for inheritance tax using simple examples.
Computing lifetime tax
There are two types of lifetime gifts – gifts to individuals and gifts to trusts. Gifts to individuals are called potentially exempt transfers (PETS) and are tax free while the donor is alive but do consume the annual exemption of £3,000. I will not be covering the other exemptions available in this article.
On the other hand, gifts to trusts are called chargeable lifetime transfers and taxed immediately at 20%. A transfer of value for IHT is computed based on loss in value to the donor, so if the donor is paying the tax on the CLT, the gift is net of 20% tax or 80%. As a result, the tax is 20/80 or 25%. If the question does not tell you who pays the tax, use 25%.
Whilst the donor is alive, only allocate the nil rate band to CLTs.
Simple example: Natalya
Natalya makes a gift of £400,000 to her son Sergei on 1.1.2018 and also makes a gift of £400,000 to a trust for her grandchildren on 1.1.2019. The nil rate band is £325,000 and Natalya pays the tax on the gift to the trust. Compute the lifetime tax payable.
The gift on 1.1.2018 is a PET valued at £400,000 and would consume the annual exemption of £3,000 for 17/18 and the annual exemption of £3,000 for 16/17 brought forward. The value of the PET is therefore £400,000 – £6,000 = £394,000 and is tax free while Natalya is alive.
The gift on 1.1.2019 is a CLT valued at £400,000 and would consume the annual exemption of £3,000 for 18/19. The annual exemption for 17/18 has already been utilised by the PET so is not available.
The value of the CLT is therefore £400,000 – £3,000 = £397,000 and to find the IHT, we simply deduct the NRB and tax at 25%.
The tax payable by Natalya is £397,000 – £325,000 = £72,000 x 25%= £18,000.
If the CLT falls between the 6 April–30 September, the tax is payable on the 30 April of the next tax year. On the other hand, if the CLT falls in the second half of the tax year (1 October–5 April), the tax is payable six months after the end of month in which the gift took place.
Natalya made the CLT on 1.1.2019 so the £18,000 tax is payable on 31.7.2019.
The gross chargeable transfer is £397,000 (net) + £18,000 (tax) = £415,000.
Computing extra tax on death
If the donor dies within seven years of the lifetime gift, the gift is now taxed at 40% and results in an additional tax liability payable by the donee, six months after the end of month of death.
The tax on death is reduced by taper relief and by any lifetime tax previously paid. The percentages for taper relief are provided in the tax rates.
Simple example: Natalya
Let’s now assume that Natalya dies on 1 May 2023, which is less than seven years from the gifts.
Extra tax payable on PET
The PET of £394,000 took place on 1.1.2018, which is five–six years before death and 60% taper relief is available.
When computing the tax, it is important to understand that the NRB will now be allocated to the PET as it took place before the CLT. To compute the tax, we simply deduct the NRB from the gross chargeable transfer and tax it at 40%.
£394,000 – £325,000 = £69,000 x 40% = £27,600.
This tax is then reduced by 60% taper relief
£27,600 x 60% = £16,560
This means that Sergei has to pay tax of £27,600 – £16,560 = £11,040 on 30.11.2023.
Extra tax payable on CLT
The CLT of £415,000 took place on 1.1.2019, which is four-five years before death and 40% taper relief is available.
When computing the tax, it is important to understand that the NRB has already been used against the PET and is not available for the CLT. In addition, Natalya paid tax of £18,000 which can be deducted to find the tax payable on death. However, there can never be a refund of lifetime tax paid.
£415,000 x 40% = £166,000.
This tax is then reduced by 40% taper relief
£166,000 x 40% = £66,400
We can also deduct the £18,000 lifetime tax previously by Natalya.
This means that the trustees have to pay tax of £166,000 – £66,400 – £18,000 = £81,600 on 30.11.2023.
Well done! You have now understood lifetime gifts and IHT.
• Neil Da Costa is a Senior Tax Lecturer with Kaplan