For those people who are likely to have an Inheritance Tax (IHT) liability on their death the possibility is that they are already using lifetime gifting as a means of mitigating IHT. Most people are aware of the 7 year rule where lifetime gifts are concerned but many people are unaware of the 14 years rule known as the PET-trap. Generally there are three types of gifts you can make during your lifetime to reduce your estate for IHT purposes. The first being exempt transfers, such as gifts between spouses, civil partners or to charities.
The second type of gift is known as a potentially exempt transfers (PET). So long as the donor (person making the gift) survives the seven year period, and retains no benefit in the gifted asset, the value of the gift falls outside the donor’s estate for IHT purposes. If, however, the donor dies within the seven year period the value of the gift will be added back for the purpose of the IHT calculation to the total value of the deceased’s estate (known as the cumulative total) and may then be subjected to IHT.
The third type of gift is known as a chargeable lifetime transfer (CLT). Gifts of this nature normally arise when the donor transfers assets into a trust during their lifetime. Where a donor has made a both a PET and a CLT it may be necessary to look back 14 years from the date of death to determine the cumulative total. This is known as the PET-trap
If the value of the CLT, and any other CLTs made within the previous seven years, exceeds the nil rate band which is currently £325,000 (2018/19) then there is an immediate IHT liability to be paid at the lifetime rate of 20% on the excess value above the nil rate band. So long as the donor survives seven years from the date of this gift there will be no further IHT to pay.
However, matters become more complex if the donor makes a CLT more than seven years before their death but also makes a second gift of a PET within seven years of the first CLT gift. This could result in the earlier CLT being caught by the IHT regime, meaning the possibility of IHT being paid on the gifts made up to 14 years pre-death.
Here is a working example to help explain this complex issue:
- year one: Eric made a CLT to a trust of £75,000
- year six: Eric made a PET of £300,000 to his son
- year 10: Eric dies
You may be under the impression that because Eric died more than seven years since he made the CLT to the trust this gift cannot be caught by the IHT regime and because the PET made to his son is below the NRB that this will also not be subject to IHT. However, this is not true and it is important to consider the events that have taken place in the seven years prior to the PET.
Considering this example further you need to be aware that although there is no IHT to pay on the original CLT made in year one it does reduce the available nil rate of band. The available nil rate bad is calculated as follows:
Nil rate band £325,000
Less the value of the CLT (£ 75,000)
Available nil rate band £250,000
So to calculate the amount of IHT payable on the failed PET made in year six you would need to apply the following:
- value of PET: £300,000
- less available nil rate band : (£250,000)
- IHT @ 40% of £50,000: £20,000
As you will see a CLT does not necessarily itself create an IHT liability on death. However, it is important to be aware that the CLT could reduce the available nil rate band to offset against any successive PET where death occurs within seven years of the PET and fourteen years of the original CLT.
If you wish to consider your own Inheritance Tax planning please do call our private client department to discuss your requirements in more detail.