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

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Overview

Understanding Inheritance Tax (IHT) related to both lifetime and death transfers is vital for SQE1 FLK2 exam candidates. This guide delves into the relationship between Potentially Exempt Transfers (PETs), Lifetime Chargeable Transfers (LCTs), and the effects of death on these processes. Understanding these ideas is key for future legal professionals to manage estate planning effectively and offer knowledgeable advice on reducing tax liabilities lawfully.

Potentially Exempt Transfers (PETs)

Potentially Exempt Transfers are gifts made during a donor's lifetime that may avoid IHT if the donor lives for seven years after giving. This allows individuals to lower the taxable estate's value.

Key Points on PETs

  1. Seven-year rule: If the donor dies within seven years of the gift, its value is included in their estate for IHT calculation at the current rate.

  2. Taper Relief: Provides a decreasing IHT rate on PETs given three to seven years before death, lowering by 20% for each complete year after the third.

  3. Suspensions: The seven-year rule can pause due to certain circumstances like the donor's mental incapacity or entry into a care home.

Example: The Art Collection Gift

Consider Liam, who gifts his granddaughter, Sophia, an art collection worth £500,000 on 1 January 2020:

  • If Liam lives until 2 January 2027, the gift is fully exempt from IHT.

  • Should he die on 1 June 2025 (5 years and 5 months after), the gift incurs IHT with taper relief reducing it by 60%.

  • Assuming a nil rate band of £325,000 and a 40% IHT rate, the liability would be:

    IHT Liability = (£500,000 - £325,000) × 40% × 60% = £42,000

This highlights the importance of timing in estate planning and potential tax savings through PETs.

Lifetime Chargeable Transfers (LCTs)

LCTs typically involve asset transfers into trusts and attract IHT if exceeding the nil rate band. These are reassessed at full IHT rates if the donor dies within seven years.

Key Points on LCTs

  1. Immediate Tax Charge: Transfers over the nil rate band incur a 20% tax upfront.

  2. Reassessment on Death: If the donor passes within seven years, LCTs are reassessed, possibly resulting in more IHT for the estate.

  3. Ongoing Liability: Even after seven years, trust assets might still face IHT, including a 10-yearly charge and an exit charge when distributed.

Example: Trust Setup

Rachel sets up a discretionary trust on 1 March 2021 with assets valued at £750,000:

  1. Immediate Tax Charge:

    Taxable Amount = £750,000 - £325,000 (nil rate band) = £425,000
    Initial Tax Charge = £425,000 × 20% = £85,000

  2. Subsequent Death Scenario:
    If Rachel dies on 1 September 2024:

    • Recalculation at death rates gives a full IHT liability of £170,000 (40% on £425,000).
    • Applying taper relief (80% of full charge as death occurred between 3-4 years):
      Adjusted Liability = £170,000 × 80% = £136,000
    • Credit for lifetime tax paid:
      Additional Tax Due = £136,000 - £85,000 = £51,000

This example illustrates immediate and deferred tax liabilities associated with LCTs and the importance of meticulous long-term planning.

The Effect of Death on Transfers

A donor’s death within seven years of a PET or LCT initiates several tax consequences:

  1. Recalculated IHT: Transfers are reassessed at current death tax rates, potentially heightening the estate’s IHT liability.

  2. Taper Relief: Offers a gradual decrease in IHT on transfers made between three and seven years beforehand.

  3. Aggregation and Order: PETs and LCTs combine with the death estate to determine the total value. Transfers are considered by date, applying the nil rate band to the earliest first.

Taper Relief Table

Years between transfer and deathTaper relief (percentage of full tax charge)
0-3100%
3-480%
4-560%
5-640%
6-720%
7+0% (full exemption)

Complex Scenario: Multiple Transfers

Consider Eleanor, who made these transfers:

  1. 1 May 2018: PET of £200,000 to her son
  2. 1 June 2020: LCT of £400,000 to a discretionary trust
  3. 1 July 2022: PET of £300,000 to her daughter

Eleanor dies on 1 August 2024. The nil rate band is £325,000.

Analysis:

  1. The 2018 PET is outside the seven-year period and exempt.
  2. The 2020 LCT (4 years, 2 months before death):
    • Initially taxed at 20% on £75,000, resulting in £15,000 paid.
    • Recalculated at 40%, with 60% taper relief applied.
    • Additional tax due: (£75,000 × 40% × 60%) - £15,000 = £3,000
  3. The 2022 PET (2 years, 1 month before death):
    • Fully chargeable at 40%.
    • Tax due: £300,000 × 40% = £120,000

This illustrates how different transfers interact and the impact of timing on tax calculations.

Strategic Planning Approaches

Effective estate planning requires careful management of PETs and LCTs to optimize tax relief and minimize IHT burdens. Strategies include:

  1. Staggered Gifting: Regularly giving to use annual exemptions and gradually reduce the estate’s value.

  2. Using Trusts: Employing trusts to both manage asset transfers and maintain some control.

  3. Nil Rate Band Usage: Strategically applying nil rate bands, including transferrable options between spouses.

  4. Timing Transfers: Combining LCTs and PETs to optimize nil rate band use, significantly cutting IHT.

Conclusion

Comprehending the subtleties of PETs, LCTs, and IHT is critical for effective estate planning. By strategically executing transfers and mastering tax rules, executors and beneficiaries can realize favorable financial outcomes. Continued study in these areas is encouraged to align legal strategies with financial objectives.