According to recent research, the amount of Inheritance Tax (IHT) paid on gifts rose by £13 million when compared to the previous year.
Many people incorporate lifetime gifts to loved ones into their estate planning, with the goal of reducing their taxable estate.
However, confusion around the ‘seven-year’ rule and Potentially Exempt Transfers (PETs) can result in families inadvertently paying more tax.
The uptick in IHT indicates that lifetime gifting should be approached carefully, as assets are not guaranteed to fall outside an estate.
What is the seven-year rule?
Many outright gifts to individuals are classified as PETs for IHT purposes. If a donor survives seven years from the date of the gift, it falls entirely outside the scope of IHT.
The clock starts when a gift is actually made, not when it was promised or merely intended.
If the donor dies within seven years, the gift may then be subject to IHT, although a taper relief may apply.
Taper relief is only applied to the portion of a gift that surpasses the donor’s nil-rate band of £325,000. It only reduces the rate of tax and not the value of the gift itself.
The relief is applied in line with how long the donor survived after a gift was made:
- Less than three years: the full rate (40 per cent) of IHT typically applies
- Three to four years: 32 per cent IHT rate applies
- Four to five years: 24 per cent IHT rate applies
- Five to six years: 16 per cent IHT rate applies
- Six to seven years: eight per cent IHT rate applies
- Seven or more years: zero per cent IHT
Aside from the seven-year rule, individuals can benefit from the annual gift exemption, which allows tax-free gifts of up to £3,000 to be made every year.
These gifts are immediately exempt from IHT, without the need to survive for seven years after they have been made.
What are the potential issues with PETs?
While using PETs as part of estate planning can be highly effective in reducing a tax bill, it is not without associated risks.
UK families paid £315 million in IHT on gifts over the past year, which indicates many families may not be making full use of available gifting exemptions and reliefs.
As mentioned previously, there is the unfortunate possibility the donor may not survive seven years after making the gift, which can increase the taxable estate.
Moreover, any gift must be a legitimate donation, with the recipient receiving full and exclusive benefit of the asset.
For example, a donor could not gift a house but continue to live in it without paying rent at an adequate market level.
If the donor does not fully relinquish enjoyment of an asset, it is known as a Gift with Reservation of Benefit (GWROB), which is vastly different from a PET.
GWROBs remain inside the taxable estate upon death, despite the fact that they were given away, offsetting any desired tax saving.
How can gifts be kept effective?
Clearly documenting gifts, particularly substantial ones, can provide clear evidence of the amount, intention and date of a transaction.
If HMRC were to scrutinise the estate, a well-kept paper trail can make the difference between the gift being a PET and being included in the taxable estate.
Overall, gifting strategies are often most effective when used in tandem with other estate planning strategies.
Combining annual exemptions with PETs, made over multiple years, can create a greater reduction in the taxable estate.
In any case, a change of circumstances warrants a review of an estate structure to ensure gifting strategies reflect the individual’s current situation.
Speak to an accountant
While a solicitor can provide bespoke guidance on IHT planning and the use of lifetime gifts, assessing whether donations could be treated as PETs, an accountant can assess whether a gift is likely to be treated as a GWROB by HMRC, ensuring there is a clear, documented record of transactions.
By reviewing your estate planning arrangements, we can identify any extra opportunities to utilise reliefs and minimise future tax liabilities.
Early financial advice can help minimise IHT liabilities and ensure gifting arrangements deliver the greatest possible tax efficiency.
Considering lifetime gifts in your estate planning? Please get in touch with our accountants for guidance on managing IHT.
