Inheritance Tax on lifetime transfers and transfers on death - Effect of death on PETs and LCTs

Learning Outcomes

After studying this article, you will be able to explain how Inheritance Tax (IHT) applies to lifetime transfers and transfers on death, including the effect of death on Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs). You will be able to apply the seven-year rule, calculate IHT on failed PETs and LCTs, use taper relief, and identify the impact of these rules on estate planning and exam scenarios.

SQE1 Syllabus

For SQE1, you are required to understand the effect of death on lifetime transfers for IHT purposes. Focus your revision on:

• the distinction between Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)
• how death within seven years of a PET or LCT affects IHT liability
• the operation and calculation of taper relief
• the order and interaction of gifts and the nil-rate band
• credit for lifetime tax paid on LCTs
• practical calculation of IHT in scenarios involving multiple gifts and death

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.

1. What happens to a PET if the donor dies within seven years of making the gift?
2. How is IHT calculated on an LCT if the donor dies within seven years of the transfer?
3. What is the effect of taper relief, and when does it apply?
4. If a person makes several gifts in the seven years before death, how is the nil-rate band applied?

Introduction

Inheritance Tax (IHT) is charged on transfers of value made during a person’s lifetime and on their death. For SQE1, you must understand how death affects the IHT treatment of gifts made during life—especially Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs). This article explains the key rules, calculations, and practical implications.

Potentially Exempt Transfers (PETs)

A Potentially Exempt Transfer (PET) is a gift made by an individual to another individual (or into certain trusts for disabled persons or bereaved minors) that is exempt from IHT if the donor survives for seven years after making the gift.

Key Term: Potentially Exempt Transfer (PET) A lifetime gift by an individual to another individual (or a qualifying trust) that is exempt from IHT if the donor survives seven years, but becomes chargeable if the donor dies within that period.

If the donor survives seven years, the PET is ignored for IHT. If the donor dies within seven years, the PET “fails” and is treated as a chargeable transfer. The value of the PET is included in the donor’s estate for IHT purposes.

Effect of Death on PETs

• If the donor dies within seven years, the PET is included in the cumulative total of chargeable transfers.
• The PET is set against the nil-rate band (currently £325,000).
• Any excess above the nil-rate band is taxed at the death rate (40%).
• Taper relief may reduce the tax payable if death occurs between three and seven years after the gift.

Key Term: nil-rate band The threshold up to which IHT is charged at 0%. Gifts and estates above this amount are taxed at 40% (subject to reliefs and exemptions).

Worked Example 1.1

Scenario:
In 2017, Alice gives £200,000 to her son. In 2021, she gives £200,000 to her daughter. Alice dies in 2023, having made no other gifts.

Answer:
Both gifts are PETs. Alice died within seven years of both gifts, so both become chargeable. The gifts are applied in chronological order against the nil-rate band (£325,000):

• The 2017 gift (£200,000) uses £200,000 of the nil-rate band, leaving £125,000.
• The 2021 gift (£200,000) uses the remaining £125,000 of the nil-rate band; the excess £75,000 is taxed at 40%.
• IHT on the second gift: £75,000 × 40% = £30,000 (before taper relief).

Lifetime Chargeable Transfers (LCTs)

A Lifetime Chargeable Transfer (LCT) is a gift made during life that is immediately chargeable to IHT—typically a transfer into a discretionary trust or a company.

Key Term: Lifetime Chargeable Transfer (LCT) A lifetime gift (usually to a trust or company) that is immediately chargeable to IHT at 20% on the excess above the nil-rate band, with a further charge if the donor dies within seven years.

At the time of the LCT, IHT is charged at 20% on the value above the nil-rate band. If the donor survives seven years, no further tax is due. If the donor dies within seven years, the transfer is recalculated at the death rate (40%), and credit is given for any lifetime tax already paid.

Effect of Death on LCTs

• If the donor dies within seven years, the LCT is recalculated at the death rate (40%).
• The value of the LCT is included in the cumulative total of chargeable transfers.
• Credit is given for any IHT paid at the time of the LCT.
• Taper relief may reduce the tax payable if death occurs between three and seven years after the transfer.

Worked Example 1.2

Scenario:
Ben transfers £500,000 into a discretionary trust in 2019. He pays IHT of 20% on £175,000 (£500,000 - £325,000) = £35,000. Ben dies in 2022.

Answer:
The LCT is recalculated at 40%: £175,000 × 40% = £70,000.
Ben died three years after the transfer, so no taper relief applies.
Credit for lifetime tax paid: £70,000 - £35,000 = £35,000 additional IHT due.

Taper Relief

Taper relief reduces the IHT payable on failed PETs and LCTs if the donor dies more than three years but less than seven years after the transfer. It does not reduce the value of the gift—only the tax payable.

Key Term: taper relief A reduction in the IHT payable on gifts made three to seven years before death, based on the time elapsed between gift and death.

Worked Example 1.3

Scenario:
Clare gives £400,000 to her brother in 2018. She dies in 2023. No other gifts were made.

Answer:
Clare died five years after the gift. The nil-rate band (£325,000) is applied to the gift, leaving £75,000 chargeable.
Tax at 40% = £30,000.
Taper relief for 4–5 years: 60% of £30,000 = £18,000 IHT payable.

Order of Gifts and the Nil-Rate Band

When a person makes multiple gifts in the seven years before death, gifts are applied against the nil-rate band in chronological order. Earlier gifts reduce the nil-rate band available for later gifts and for the death estate.

Worked Example 1.4

Scenario:
David gives £200,000 to his daughter in 2016, and £200,000 to his son in 2020. He dies in 2022.

Answer:
The 2016 gift (£200,000) uses £200,000 of the nil-rate band.
The 2020 gift (£200,000) uses the remaining £125,000 of the nil-rate band; the excess £75,000 is taxed at 40%.
IHT on the second gift: £75,000 × 40% = £30,000 (before taper relief).

Credit for Lifetime Tax Paid

If IHT was paid at the time of an LCT, credit is given for that tax when recalculating IHT on death. If the recalculated tax is less than the lifetime tax paid, no refund is given.

Practical Implications for Estate Planning

• Early lifetime gifts are more likely to escape IHT if the donor survives seven years.
• PETs to individuals are generally preferable for IHT planning, as they may become exempt.
• LCTs (e.g., gifts to discretionary trusts) may trigger immediate IHT charges and further tax if the donor dies within seven years.
• Taper relief only reduces the tax, not the value of the gift.

Exam Warning

For SQE1, always check the date of each gift and the date of death. Apply the nil-rate band in chronological order, and remember that taper relief applies only to the tax, not the value of the gift.

Revision Tip

When answering calculation questions, write out the gifts and dates in order, apply the nil-rate band step by step, and show all working for taper relief and credits.

Key Point Checklist

This article has covered the following key knowledge points:

• PETs are exempt from IHT if the donor survives seven years; if not, they become chargeable.
• LCTs are immediately chargeable to IHT; if the donor dies within seven years, a further charge arises at the death rate.
• Taper relief reduces the IHT payable on gifts made three to seven years before death.
• The nil-rate band is applied to gifts in chronological order.
• Credit is given for lifetime tax paid on LCTs if a further charge arises on death.
• Early lifetime gifts and use of annual exemptions can reduce IHT exposure.

Key Terms and Concepts

• Potentially Exempt Transfer (PET)
• Lifetime Chargeable Transfer (LCT)
• nil-rate band
• taper relief