Inheritance tax - Application and calculations

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Overview

Inheritance Tax (IHT) plays a key role in UK tax law, affecting estate planning and wealth transfer. For those studying for the SQE1 FLK1 exam, a solid grasp of IHT principles, calculations, and applications is important. This guide offers a detailed look at IHT, with a focus on calculations, thresholds, reliefs, and complex scenarios. Understanding these concepts will equip candidates to handle exam questions and provide sound advice in legal practice.

Key Thresholds and Rates

The Nil-Rate Band (NRB)

The Nil-Rate Band (NRB) is the amount an estate can pass on tax-free, currently set at £325,000. Estates above this limit face an IHT rate of 40%.

Example: An estate of £500,000 results in an IHT on £175,000, leading to £70,000 in tax (£175,000 x 40%).

The Residence Nil-Rate Band (RNRB)

Introduced in 2017, the RNRB offers an additional £175,000 tax-free allowance if the main residence passes to direct descendants. It's combined with the NRB.

For estates over £2 million, the RNRB decreases by £1 for every £2 above this threshold.

Example: An estate of £500,000, with the main home going to a child, has no IHT liability:

  • Total Estate Value: £500,000
  • NRB: £325,000
  • RNRB: £175,000
  • Taxable Portion: £0
  • IHT Payable: £0

Spousal Transfers and the Unused NRB

Transfers between spouses or civil partners are IHT-exempt. Any unused NRB of a deceased spouse can transfer to the surviving spouse, potentially doubling the NRB to £650,000.

Example: John leaves an estate of £400,000, survived by Mary with an unused NRB of £75,000, boosting her NRB to £400,000.

Lifetime Transfers and Potentially Exempt Transfers (PETs)

Gifts over £3,000 may be subject to IHT if the donor dies within seven years. These are Potentially Exempt Transfers (PETs).

The Taper Relief System

Taper relief reduces the tax on PETs made three to seven years before death.

Years Since GiftTaper ReliefTaxable Portion
3-4 years20%80%
4-5 years40%60%
5-6 years60%40%
6-7 years80%20%

Note: Taper relief affects tax payable, not the gift's value.

Calculating Inheritance Tax

Calculating IHT involves these steps:

Step 1: Estate Value

  • Assets: Include property, savings, investments, business interests, and personal items.
  • Liabilities: Subtract mortgages, debts, and funeral costs.

Step 2: Apply Nil-Rate Bands and Allowances

  • NRB and RNRB: Deduct these from the net estate.

Step 3: Account for Reliefs and Exemptions

Various reliefs and exemptions can decrease the IHT:

  • Business Property Relief (BPR)

    • 100% Relief: For unquoted shares, sole trader businesses, or partnerships.
    • 50% Relief: For controlling shares in listed companies.

  • Agricultural Property Relief (APR)

    • Applies to agricultural property under specific conditions.

  • Charity Relief: Gifts to registered charities are IHT-exempt. Estates donating 10% or more to charity enjoy a reduced rate of 36%.

Eligibility for BPR and APR usually requires a two-year ownership period.

Step 4: Calculate IHT Liability

Multiply the taxable estate portion (after reliefs and allowances) by 40%.

Complex Examples and Applications

Example 1: PET and Taper Relief

Mrs. Smith gives £500,000 to her daughter on January 1, 2015, and dies on July 1, 2019. Her estate is valued at £1,000,000.

Calculation:

  1. PET Value: £500,000
  2. NRB at Death: £325,000
  3. Taxable PET: £175,000
  4. Years Since Gift: 4.5
  5. Taper Relief: 40%
  6. Tax on PET: £70,000
  7. Taper Relief: £28,000
  8. Final Tax: £42,000

Example 2: Estate with Business Assets

Mr. Jones dies with an estate of £2,500,000, including:

  • Residence: £1,000,000
  • Business Assets: £800,000
  • Trust Assets: £500,000
  • Other Assets: £200,000

Calculation:

  1. Gross Estate: £2,500,000
  2. Less BPR: (£800,000)
  3. Taxable Estate: £1,700,000
  4. Apply NRB: (£325,000)
  5. Apply RNRB: (£175,000)
  6. Net Taxable Estate: £1,200,000
  7. IHT at 40%: £480,000

Trust assets aren't in the estate but may face separate charges.

Interaction with Other Taxes

Capital Gains Tax (CGT)

Inherited assets are usually CGT-exempt initially, but may face CGT upon sale. This is complex with:

  • Sales by personal representatives
  • Asset allocations to beneficiaries
  • Holdover relief on lifetime gifts

Income Tax

Assets benefiting from IHT relief may still incur income tax.

Legal Implications and Exam Considerations

Role of Trusts

Trusts are vital for IHT planning, allowing assets to be held for beneficiaries and minimizing IHT.

IHT Exceptions and Legal Challenges

Some assets and transactions are IHT-exempt. Recognizing these is crucial.

  • Gifts to spouses or civil partners
  • Charitable donations
  • Gifts to institutions like museums

Court's Role in IHT Disputes

Disputes may arise over asset value, exemptions, and trust interpretations. Courts ensure IHT is applied fairly.

Recent rulings, such as HMRC v Parry & Ors [2020] UKSC 35, have refined IHT rules.

Conclusion

Understanding Inheritance Tax is key for SQE1 FLK1 success and legal practice. Candidates should focus on:

  1. NRB and RNRB thresholds
  2. PETs and taper relief
  3. BPR and APR use
  4. IHT interactions with other taxes
  5. Trusts in IHT planning
  6. Legal precedents affecting IHT

Staying updated with IHT legislation ensures relevance for both exams and practice.