Inheritance Tax on lifetime transfers and transfers on death - Lifetime transfers: Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)

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Overview

Inheritance Tax (IHT) is a significant aspect of estate planning, with a focus on lifetime transfers being vital for the SQE1 FLK2 exam. Understanding the details of Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs) is key to successful tax planning and wealth management. This guide covers the details of these transfers, their tax effects, and strategic applications, equipping students with the knowledge needed for the FLK2 exam and future legal practice.

Potentially Exempt Transfers (PETs): Essentials and Advanced Insights

Potentially Exempt Transfers are fundamental to IHT planning, providing a tax-efficient gifting option, conditioned on survival.

Key Features of PETs

  1. Seven-Year Rule: The gift is fully exempt if the donor survives seven years from the date of the transfer.
  2. Recipient Eligibility: Primarily includes gifts to individuals or certain qualifying trusts like disabled person's trusts.
  3. Taper Relief: Reduces IHT liability on a sliding scale if death occurs between three and seven years after the gift.

PET Calculations

Consider this example to illustrate PET calculations:

Eleanor gifts £500,000 to her daughter on 1 May 2020. She dies on 1 June 2024, with an estate valued at £2,000,000. Assuming a nil-rate band of £325,000 and no other lifetime gifts:

  1. PET value: £500,000
  2. Taper relief (death occurred 4 years after the gift): 20% reduction
    • Adjusted PET value: £500,000 * 80% = £400,000
  3. IHT on the PET:
    • Taxable amount: £400,000 - £325,000 = £75,000
    • IHT on PET: £75,000 * 40% = £30,000
  4. IHT on the estate:
    • Taxable estate: £2,000,000
    • IHT on estate: £2,000,000 * 40% = £800,000
  5. Total IHT liability: £30,000 (PET) + £800,000 (estate) = £830,000

This example shows the importance of careful calculations for the FLK2 exam.

Lifetime Chargeable Transfers (LCTs): Detailed Study and Trust Considerations

Lifetime Chargeable Transfers require immediate attention to tax aspects, often involving trusts.

Key Features of LCTs

  1. Immediate Tax Liability: LCTs typically result in an immediate IHT charge, usually at a reduced rate of 20%.
  2. Trust Involvement: Commonly linked to discretionary trusts or other non-qualifying trusts.
  3. Potential for Additional Charges: Additional taxes may apply if the donor dies within seven years, with credit for tax already paid.

Trusts and LCTs

Exploring the treatment of LCTs in complex trust structures is essential:

Discretionary Trust Example

James sets £1,000,000 into a discretionary trust on 1 July 2022. He has made no previous chargeable transfers and hasn't used his annual exemptions for the current or past year.

  1. Calculate the chargeable transfer:
    • Gross transfer: £1,000,000
    • Less annual exemptions: £1,000,000 - (£3,000 * 2) = £994,000
  2. Apply the nil-rate band:
    • Nil-rate band (assuming £325,000)
    • Taxable amount: £994,000 - £325,000 = £669,000
  3. Calculate immediate IHT charge:
    • IHT at 20% on £669,000 = £133,800
  4. Consider potential additional charges:
    • If James dies within seven years, an additional 20% may apply on the amount exceeding the nil-rate band, subject to taper relief.

This example illustrates the immediate tax consequences of LCTs and their complexity in trust planning.

Exemptions and Reliefs: In-Depth Review

Understanding exemptions and reliefs is crucial for reducing IHT liability and optimizing estate strategies.

Key Exemptions and Reliefs

  1. Annual Exemption: £3,000 per tax year, with carry-forward of one unused year.
  2. Normal Expenditure Out of Income: Regular gifts that do not affect the donor's standard of living are exempt.
  3. Business Property Relief (BPR): Up to 100% relief on qualifying business assets.
  4. Agricultural Property Relief (APR): Up to 100% relief on qualifying agricultural property.

BPR Example

Sarah owns a business valued at £2,000,000. She gifts 25% of the business to her son. Assuming the business qualifies for 100% BPR:

  1. Value of gift: £2,000,000 * 25% = £500,000
  2. BPR applied: £500,000 * 100% = £500,000
  3. Chargeable value for IHT: £500,000 - £500,000 = £0

This example demonstrates how BPR can significantly reduce or eliminate IHT on business assets.

Strategic Planning and Tax Interaction

Effective IHT planning requires strategic consideration of different taxes.

IHT and Capital Gains Tax (CGT) Interaction

The relationship between IHT and CGT is crucial when considering lifetime transfers:

Hold-Over Relief Example

Michael owns shares in a private company, bought for £100,000, now valued at £1,000,000. He transfers these into a discretionary trust:

  1. IHT implications:
    • Chargeable transfer of £1,000,000 (assuming no available nil-rate band)
    • Immediate IHT charge: £1,000,000 * 20% = £200,000
  2. CGT implications:
    • Potential gain: £1,000,000 - £100,000 = £900,000
    • Hold-over relief claim: Defers CGT liability to trustees
  3. Result:
    • IHT paid immediately
    • CGT deferred, with trustees acquiring shares at Michael's base cost of £100,000

This underscores the need to consider both IHT and CGT in planning.

Multi-Year Planning Strategies

Comprehensive estate planning often involves multi-year strategies to maximize efficiency:

  1. Staggered Gifting: Making a series of gifts over several years to utilize annual exemptions and manage IHT liability.
  2. Trust Combinations: Using different types of trusts to balance immediate tax costs with long-term flexibility.
  3. Business Asset Structuring: Reorganizing business assets to maximize available reliefs while maintaining control.

Conclusion

Understanding Potentially Exempt Transfers and Lifetime Chargeable Transfers is necessary for success in the SQE1 FLK2 exam and effective estate planning. This guide has explored calculations, trust implications, and strategic considerations, offering the depth of knowledge required. By considering the relationship between different tax aspects, candidates can approach IHT planning with confidence and precision.

Key points to remember:

  • The seven-year survival rule for PETs and its impact on IHT
  • Immediate tax aspects of LCTs and their connection to trust structures
  • Strategic use of exemptions and reliefs to reduce IHT
  • The relationship between IHT and other taxes, particularly CGT
  • The importance of long-term planning strategies