Inheritance Tax on lifetime transfers and transfers on death - Overview of Inheritance Tax (IHT)

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Overview

Inheritance Tax (IHT) is a key aspect of estate planning and wealth transfer, affecting gifts made during a person's lifetime and the distribution of assets after their death. For SQE1 FLK2 exam candidates, a strong understanding of IHT principles is essential, shaping estate planning strategies and tax liability management. This article examines IHT application to lifetime transfers and transfers on death, covering concepts such as Potentially Exempt Transfers (PETs), the nil rate band, and various exemptions and reliefs.

Lifetime Transfers and Potentially Exempt Transfers (PETs)

Lifetime transfers are central to IHT planning, with Potentially Exempt Transfers (PETs) enabling tax-efficient wealth transfer. PETs are gifts made during an individual's lifetime that may be exempt from IHT if certain conditions are met.

Key Principles of PETs

  1. Seven-Year Rule: A PET becomes fully exempt from IHT if the donor survives for seven years after making the gift.

  2. Taper Relief: If the donor dies within three to seven years after making the gift, taper relief might apply, lowering the IHT liability on a sliding scale.

  3. Valuation: PETs are assessed at the time of the gift, not at the donor's death.

  4. Cumulative Effect: PETs are considered along with other transfers when calculating IHT liability.

Strategic Considerations

  • Timing of Gifts: Carefully planning the timing of substantial gifts can maximize the chance of full IHT exemption.
  • Record-Keeping: Maintaining detailed records of PETs is essential for accurate IHT calculations.
  • Interaction with Nil Rate Band: Understanding how PETs interact with the nil rate band is key for optimizing IHT liability.

Transfers on Death and the Nil Rate Band

Transfers on death are central to IHT assessment, with the nil rate band playing a major role in determining tax liability.

Nil Rate Band (NRB)

  • Current Threshold: The standard nil rate band is set at £325,000 (as of 2023/24).

  • Transferability: Unused NRB can be transferred between spouses or civil partners, potentially doubling the threshold.

  • Seven-Year Look-Back: The NRB is reduced by the value of PETs made within seven years of death.

Residence Nil Rate Band (RNRB)

  • Current Amount: Up to £175,000 (2023/24), in addition to the standard NRB.
  • Eligibility: Available when a residence is passed to direct descendants.
  • Tapering: The RNRB is reduced for estates valued over £2 million.

Calculation Example

Estate Value: £2,500,000
Standard NRB: £325,000
RNRB: £175,000
Taxable Estate: £2,500,000 - (£325,000 + £175,000) = £2,000,000
IHT Liability (at 40%): £2,000,000 × 0.40 = £800,000

Special Exemptions and Reliefs

Knowing IHT exemptions and reliefs is key for effective estate planning and minimizing tax liabilities.

Key Exemptions

  1. Spouse or Civil Partner Exemption: Transfers between spouses or civil partners are generally exempt from IHT.
  2. Annual Exemption: Gifts up to £3,000 per tax year are exempt from IHT.
  3. Small Gifts Exemption: Gifts up to £250 per recipient per tax year are exempt.
  4. Normal Expenditure Out of Income: Regular gifts from surplus income can be exempt.
  5. Charitable Donations: Gifts to qualifying charities are exempt from IHT.

Reliefs

  1. Business Property Relief (BPR): Up to 100% relief on qualifying business assets.
  2. Agricultural Property Relief (APR): Offers up to 100% relief on qualifying agricultural property.
  3. Woodlands Relief: Allows deferral of IHT on the value of timber until it is sold.

Trusts and Their IHT Consequences

Trusts are sophisticated instruments in estate planning, presenting both opportunities and challenges in IHT management.

Types of Trusts and Their IHT Treatment

  1. Bare Trusts: Assets are treated as belonging to the beneficiary for IHT purposes.
  2. Interest in Possession Trusts: The value of the trust is part of the beneficiary's estate for IHT purposes.
  3. Discretionary Trusts: Subject to their own IHT regime, including entry charges, periodic charges, and exit charges.

Key Considerations

  • Settlor-Interested Trusts: Assets where the settlor benefits are usually treated as part of the settlor's estate for IHT purposes.
  • Interaction with PETs and CLTs: Understanding how trusts interact with other lifetime transfers is vital for comprehensive IHT planning.
  • Use of Pilot Trusts: Multiple trusts established on different days can be strategically employed to maximize available NRBs.

Advanced Planning Strategies

  1. Lifetime Asset Depletion: Systematically reducing the estate value through lifetime gifts and expenditures.
  2. Business Property Succession Planning: Structuring business ownership to maximize BPR and minimize IHT liability.
  3. Charitable Legacy Planning: Incorporating charitable gifts to reduce overall IHT liability and support philanthropic goals.
  4. Life Insurance in Trust: Using life insurance policies written in trust to provide liquidity for IHT payment without increasing the taxable estate.
  5. Pension Planning: Utilizing pension funds as an IHT-efficient wealth transfer mechanism.

Conclusion

A solid command of Inheritance Tax is essential for SQE1 FLK2 exam success and effective estate planning. Important points to remember include:

  • The importance of the seven-year rule for PETs and strategic lifetime gifting
  • Proper use of nil rate bands, including the RNRB
  • Utilizing exemptions and reliefs to minimize IHT liability
  • Understanding the complex IHT effects of different trust structures
  • Implementing advanced planning strategies for comprehensive estate management

By applying these principles, candidates can tackle complex IHT scenarios, provide informed advice, and develop effective estate planning strategies that balance tax efficiency with client goals.