Inheritance Tax on lifetime transfers and transfers on death - Exemptions and reliefs: general and lifetime-only exemptions

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Overview

Inheritance Tax (IHT) is a major consideration in estate planning and wealth transfer, impacting both lifetime gifts and distribution after death. For SQE1 FLK2 exam candidates and legal professionals, a robust understanding of IHT exemptions and reliefs is vital for effectively managing estates and planning taxes. This article examines key exemptions and reliefs, outlining their application, limitations, and strategic importance in advanced legal practice and exam preparation.

General Exemptions

Spouse or Civil Partner Exemption

Transfers between UK-domiciled spouses or civil partners are fully exempt from IHT. However, transfers to non-UK domiciled spouses have a lifetime limit of £325,000. Non-UK domiciled spouses can choose to be treated as UK-domiciled for IHT, which impacts their worldwide estate.

Example: John, UK-domiciled, leaves £1 million to his UK-domiciled wife, Sarah. This is entirely exempt from IHT. If Sarah were non-UK domiciled, only £325,000 would be exempt, with the remaining £675,000 potentially subject to IHT.

Gifts to Charities

Gifts to registered charities are completely exempt from IHT, encouraging tax-efficient charitable giving.

Lifetime Transfer Exemptions

Annual Exemption

Individuals can transfer up to £3,000 each tax year without IHT charges. Unused allowances may be carried forward for one year.

Small Gifts Exemption

Allows multiple gifts of up to £250 per recipient per tax year. This cannot be combined with other exemptions for the same person within the same year.

Example: Emma gifts £250 annually to each of her five grandchildren. These gifts are exempt under the small gifts rule. If she gives £300 to one grandchild, it would not qualify and would require part of the annual exemption.

Normal Expenditure Out of Income

Regular gifts from surplus income are exempt if they do not impact the donor's standard of living. To qualify:

  1. Gifts must be part of the donor's regular spending.
  2. They must be from income (not capital).
  3. The donor must maintain their usual living standard.

Example: Margaret, a retired executive, gives her daughter £1,000 a month. Her annual income is £120,000, expenses are £80,000, and gifts total £12,000. Since the gifts are regular, from surplus income, and don't affect her lifestyle, they qualify.

Specific Reliefs

Business Property Relief (BPR)

BPR offers 50% or 100% relief on qualifying business assets, depending on certain conditions:

  1. The business must be trading.
  2. The property must have been owned for two years before the transfer.
  3. For unquoted companies, full relief applies, whereas quoted companies may get 50%.

Example: Alexandra owns an unquoted trading company worth £2 million. She transfers 50% of shares to her son. If conditions are met, the transfer qualifies for 100% BPR, reducing its value for IHT to nil.

Agricultural Property Relief (APR)

APR provides relief on the agricultural value of property, like farmland and buildings, subject to specific conditions.

Key points:

  1. 100% relief for owner-occupied land or land on a short-term grazing license.
  2. 50% relief for most tenanted land.
  3. Property must be owned and used for agricultural purposes for at least two years if owner-occupied, or seven years if tenanted.

Example: Farmer James owns 200 acres valued at £1.5 million, farmed personally for five years. Upon his death, it qualifies for 100% APR, potentially reducing IHT to zero.

Lifetime vs. Death Transfers

Potentially Exempt Transfers (PETs)

PETs are gifts exempt from IHT if the donor survives seven years after the gift. If the donor dies between 3-7 years, taper relief might reduce IHT:

  • 3-4 years: 20% reduction
  • 4-5 years: 40% reduction
  • 5-6 years: 60% reduction
  • 6-7 years: 80% reduction

Example Calculation: A PET of £500,000 made 4.5 years before death, assuming the nil-rate band of £325,000 is used:

  1. Taxable amount: £500,000
  2. IHT at 40%: £200,000
  3. Taper relief (40%): £80,000
  4. Net IHT: £120,000

Transfers on Death

Assets transferred upon death are subject to IHT, with the estate valued at the date of death. The nil-rate band (now £325,000) is applied first, followed by any exemptions or reliefs.

Residence Nil-Rate Band (RNRB): An additional band of £175,000 (2023/24) for a residence left to direct descendants, potentially increasing the total nil-rate band to £500,000 per person.

Example: Estate valued at £800,000 (including a home worth £400,000 left to children)

  • Basic nil-rate band: £325,000
  • RNRB: £175,000
  • Taxable estate: £300,000
  • IHT payable (at 40%): £120,000

Planning Considerations and Anti-Avoidance

Strategic Use of Exemptions and Reliefs

  1. Combine exemptions for larger gifts (e.g., mix annual exemption with normal expenditure out of income).
  2. Use BPR for business succession planning.
  3. Explore APR and BPR interactions for farms with diverse operations.

Anti-Avoidance Rules

HMRC has several measures to prevent the improper use of IHT exemptions and reliefs:

  1. Gift with Reservation of Benefit (GROB): If a donor retains benefits from a gift, it may still count as part of their estate.
  2. Pre-Owned Asset Tax (POAT): Targets arrangements where individuals gift assets but continue to enjoy them.

Example: Martha gifts her home to her daughter but continues living there rent-free. Without paying market rent, the property remains part of her estate for IHT.

Conclusion

A strong understanding of IHT exemptions and reliefs is essential for effective estate management and achieving legacy goals. Legal professionals can use these strategies to minimize IHT, ensure efficient asset distribution, and meet clients' goals. This knowledge is vital for the SQE1 FLK2 exam and in providing expert advice in practice.

Key points to remember:

  1. Distinguish between general and lifetime-only exemptions.
  2. Consider timing in PETs and taper relief applications.
  3. Understand BPR and APR qualifications.
  4. Be aware of anti-avoidance measures and their role in tax strategies.
  5. Assess how different exemptions and reliefs interact for maximum tax efficiency.