Making gifts of value during an individual's lifetime is a tried and trusted way of reducing their exposure to Inheritance Tax (IHT). It is important, however, to understand how taper relief works when considering gifting some of your wealth.
People you give gifts to might have to pay Inheritance Tax, but only if you give away more than £325,000 and die within seven years. This so-called ‘seven-year rule’ provides that a potentially exempt transfer (PET) becomes fully exempt if the person making the gift is still alive on the seventh anniversary of the date the gift was made.
There is a partial relief where the person making the gift dies before the seventh anniversary, but after the third anniversary. As a result, many people make large gifts later in life without taking professional advice in the belief that, if they survive at least three years, there will be some IHT relief. However, in practice the rules are not that simple.
Taper relief
This partial relief is called taper relief; when IHT is payable on a failed PET, the tax is reduced by 20% after three complete years have passed, and by further 20% increments for each subsequent year up to the seventh - when the PET becomes fully exempt.
There are some misconceptions about this relief. It is important to note that the relief applies to the tax charge and not the value of the gift. A failed PET is brought into the IHT account at its full value. This of course has a knock-on effect on how much the estate exceeds the nil rate band (NRB) by. When individuals are trying to do DIY planning, this misunderstanding can mean the estimated exposure to IHT is understated.
Using a simple case study, we can show how misconceptions about IHT legislation can occur.
Case study
Simon passed away recently. He was never married but had three children. He owned no property and had a reasonably-sized investment portfolio including listed shares and cash. Just over six years ago, Simon made a gift of £250,000 to his eldest child. The reason for doing so was partially IHT motivated and was done on the understanding that this represented one third of John's estate. Simon’s eldest child was receiving their inheritance in Simon's lifetime. The remaining amounts would be split between the other two children upon Simon's death. Simon made no other gifts during his lifetime.
As Simon died before the seventh anniversary of the gift date, the PET failed. However, the beneficiaries are broadly aware of the taper relief provisions and expect there to be an 80% reduction in the IHT bill, i.e., 80% of £250,000 x 40%. Unfortunately, this is not correct. For there to be a taper relief deduction, there must be a tax charge on the failed PET in the first place. Because the rules specify that failed PETs are subjected to IHT before the rest of the estate, there is no IHT charge as the value of the failed PET is below the NRB of £325,000. There is therefore no IHT charge to reduce.
Is there a solution?
Purely from an IHT perspective an easy answer to the problem would have been for Simon to give more value away to ensure that the gift exceeded the nil rate band. The problem is that this may not be practical in real life situations; particularly with modest-sized estates like Simon's.
Another potential solution would have been for Simon to take out a fixed term insurance policy to cover the potential IHT charge if the PET were to fail. At least that way the beneficiaries would have the insurance pay out to cover the tax charge.
This show how what is a simple aspect of IHT legislation can still be far more complicated than it appears on the surface. Taking advice prior to acting is essential. If you have any questions regarding IHT please email me at martin.johnson@torgersens.com.
Further information about Inheritance Tax can be found on the government’s website here.
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