Learning Outcomes
After reading this article, you will be able to identify and apply the rules for calculating Inheritance Tax (IHT) on both lifetime transfers and transfers on death. You will understand the distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs), the impact of the nil-rate band, the main exemptions and reliefs, and how previous gifts affect IHT liability. You will be able to apply these principles to SQE1-style scenarios.
SQE1 Syllabus
For SQE1, you are required to understand how IHT applies to lifetime transfers and transfers on death, and how to calculate the resulting tax liability. In your revision, focus on:
- the distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs)
- the effect of the nil-rate band and residence nil-rate band on IHT calculations
- the application of main exemptions and reliefs (including spouse exemption, annual exemption, business and agricultural relief)
- how to calculate IHT on death, including the impact of previous gifts within seven years
- the operation of taper relief and gifts with reservation of benefit
- the correct order and method for calculating IHT liability in SQE1-style questions
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the main difference between a potentially exempt transfer (PET) and a lifetime chargeable transfer (LCT) for IHT purposes?
- How does a gift made within seven years of death affect the nil-rate band available to the estate?
- What is the effect of the spouse exemption and annual exemption on IHT calculations?
- When does taper relief apply, and how does it affect the IHT payable on a lifetime gift?
Introduction
Inheritance Tax (IHT) is a tax on the transfer of assets, whether during a person’s lifetime or on death. For SQE1, you must be able to distinguish between the types of transfers, apply the correct exemptions and reliefs, and calculate the IHT liability in a variety of scenarios. This article explains the key principles and steps for calculating IHT on both lifetime transfers and transfers on death.
Types of Lifetime Transfers: PETs and LCTs
IHT can arise on transfers made during a person’s lifetime or on death. The rules differ depending on the type of transfer.
Potentially Exempt Transfers (PETs)
A potentially exempt transfer (PET) is a gift made by an individual to another individual (or to certain types of trusts for disabled persons). PETs are not taxed at the time of the gift. If the donor survives for seven years after making the PET, the gift becomes fully exempt from IHT. If the donor dies within seven years, the PET becomes chargeable and is included in the calculation of IHT on the estate.
Key Term: potentially exempt transfer (PET) A gift made by an individual to another individual (or to a qualifying trust) that is exempt from IHT if the donor survives seven years, but becomes chargeable if the donor dies within that period.
Lifetime Chargeable Transfers (LCTs)
A lifetime chargeable transfer (LCT) is any transfer of value that is not a PET or exempt transfer. The most common example is a gift into a discretionary trust. LCTs are immediately chargeable to IHT at the lifetime rate (currently 20%) on the value above the available nil-rate band. If the donor dies within seven years, the transfer is recalculated at the death rate (currently 40%), and credit is given for any lifetime tax already paid.
Key Term: lifetime chargeable transfer (LCT) A transfer of value (usually to a trust or company) that is immediately chargeable to IHT at the lifetime rate, with a further charge if the donor dies within seven years.
The Nil-Rate Band and Residence Nil-Rate Band
The nil-rate band (NRB) is the threshold below which IHT is charged at 0%. The standard NRB is currently £325,000. Any chargeable transfers (PETs or LCTs) made within seven years before death use up the NRB, reducing the amount available to the estate on death.
Key Term: nil-rate band (NRB) The threshold (currently £325,000) below which IHT is charged at 0%. Used up by chargeable transfers within seven years before death.
Key Term: residence nil-rate band (RNRB) An additional IHT allowance (currently £175,000) for estates where a home is left to direct descendants, subject to conditions and tapering.
Main Exemptions and Reliefs
Several exemptions and reliefs can reduce or eliminate IHT liability:
Key Term: spouse exemption Transfers between spouses or civil partners are exempt from IHT, provided both are UK domiciled.
Key Term: annual exemption Each individual can give away up to £3,000 per tax year free of IHT. Unused exemption can be carried forward one year.
Key Term: business relief Relief of 50% or 100% from IHT on qualifying business assets, such as shares in unlisted companies or interests in a business.
Key Term: agricultural relief Relief of up to 100% from IHT on qualifying agricultural property, such as farmland or farm buildings.
Other important exemptions include the small gifts exemption (£250 per person per tax year), gifts in consideration of marriage (up to specified limits), and gifts to charities (fully exempt).
Calculating IHT on Death
When a person dies, IHT is charged on the value of their estate, plus certain gifts made within the previous seven years. The calculation involves several steps:
- Identify chargeable transfers in the seven years before death: Add up the value of all PETs and LCTs made in the seven years before death, after deducting any available exemptions and reliefs.
- Apply the nil-rate band: The NRB is used up by earlier chargeable transfers, reducing the amount available to the estate.
- Calculate IHT on the estate: Any part of the estate above the available NRB (and RNRB, if applicable) is taxed at 40%.
- Apply taper relief: If a chargeable transfer was made more than three years before death, taper relief reduces the tax payable on that transfer.
- Apply exemptions and reliefs: Deduct any available exemptions and reliefs from the value of the estate and earlier gifts.
Worked Example 1.1
Aisha made a PET of £200,000 to her son five years before her death, and a gift of £100,000 to a discretionary trust (an LCT) three years before her death. At death, her estate is worth £500,000. She made no other gifts.
Question: How is the IHT liability calculated?
Answer: The PET and LCT use up £300,000 of the NRB, leaving £25,000 NRB for the estate (£325,000 − £300,000). The first £25,000 of the estate is taxed at 0%, and the remaining £475,000 is taxed at 40%. The LCT is recalculated at the death rate, with credit for any lifetime tax paid. Taper relief may reduce the tax on the LCT, as it was made three years before death.
Taper Relief
Taper relief reduces the IHT payable on chargeable transfers (PETs or LCTs) made more than three years before death. It does not reduce the value transferred, only the tax payable.
| Years between gift and death | % of full tax payable |
|---|---|
| 0–3 | 100% |
| 3–4 | 80% |
| 4–5 | 60% |
| 5–6 | 40% |
| 6–7 | 20% |
Key Term: taper relief A reduction in IHT payable on chargeable transfers made more than three years before death, based on the time elapsed.
Gifts with Reservation of Benefit
If a donor gives away an asset but continues to benefit from it (e.g., continues to live in a gifted house rent-free), the asset is treated as remaining in their estate for IHT purposes.
Key Term: gift with reservation of benefit A gift where the donor retains a benefit from the asset, causing it to be included in their estate for IHT.
The Order of Calculating IHT
For SQE1, you must follow the correct order when calculating IHT:
- List all chargeable transfers (PETs and LCTs) in the seven years before death, deducting exemptions and reliefs.
- Apply the nil-rate band to the earliest transfers first.
- Apply the residence nil-rate band if available.
- Calculate IHT at 40% on the value above the available bands.
- Apply taper relief to gifts made more than three years before death.
- Deduct any lifetime IHT already paid on LCTs.
- Apply exemptions and reliefs to the estate and earlier gifts.
Worked Example 1.2
Ben made a PET of £100,000 to his daughter six years before death, and a PET of £150,000 to his son two years before death. His estate is worth £400,000. He made no other gifts.
Question: What is the IHT liability?
Answer: The PETs total £250,000, using up that much of the NRB. The estate has £75,000 of NRB remaining (£325,000 − £250,000). The first £75,000 of the estate is taxed at 0%, and the remaining £325,000 is taxed at 40%. The PET to the daughter was made six years before death, so taper relief reduces the tax payable on that gift.
Applying Exemptions and Reliefs
Always deduct available exemptions (e.g., spouse exemption, annual exemption) and reliefs (e.g., business or agricultural relief) before calculating the IHT liability. Exemptions and reliefs can apply to both lifetime transfers and the estate on death.
Worked Example 1.3
Clara leaves her business (qualifying for 100% business relief) worth £300,000 to her son, and the rest of her estate (£400,000) to her daughter. She made no gifts in the previous seven years.
Question: How does business relief affect the IHT calculation?
Answer: The business is exempt from IHT due to 100% business relief. The NRB is applied to the rest of the estate (£400,000). If the NRB is £325,000, only £75,000 is taxed at 40%. The business relief reduces the taxable estate.
Exam Warning
For SQE1, always check the dates and values of all gifts made in the seven years before death. Failing to account for earlier gifts can lead to incorrect IHT calculations.
Revision Tip
When answering IHT calculation questions, write out the steps in order and show all workings. This helps avoid errors and ensures you apply the correct bands and reliefs.
Key Point Checklist
This article has covered the following key knowledge points:
- The distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs)
- The effect of the nil-rate band and residence nil-rate band on IHT calculations
- The main exemptions and reliefs available for IHT
- The correct order for calculating IHT on death, including the impact of previous gifts
- The operation of taper relief and gifts with reservation of benefit
- The importance of applying exemptions and reliefs before calculating IHT liability
Key Terms and Concepts
- potentially exempt transfer (PET)
- lifetime chargeable transfer (LCT)
- nil-rate band (NRB)
- residence nil-rate band (RNRB)
- spouse exemption
- annual exemption
- business relief
- agricultural relief
- taper relief
- gift with reservation of benefit
