Following the Autumn Statement, I said that I would publish a note on the current Inheritance Tax (IHT) rules if nothing changed. Before I launch into what I hope is a simple read, it’s worth explaining a bit of history…the Government has commissioned two separate groups to review IHT in recent years. Both suggested far reaching changes, not only to IHT but to the way it also interacts with Capital Gains Tax. Having received these, the Government said that they weren’t planning any significant changes. Interesting to note that both of these Government funded groups are no more!
More recently, the Conservatives said that they may consider abolishing it entirely. So with all this “noise”, coupled with the fact that the bulk of the legislation was first drafted in 1984, it stands to reason that at some point it will change. That being said, unless the changes are to the rate of tax or the withdrawal of a relief, a rewrite is a pretty big job and it may therefore be wise not to wait for new rules to come in, but to plan in as flexible way as possible under current rules.
You’ll note that in my explanations, I use the term “broadly” and that is because, as with all taxes, there are exceptions to the rule. Therefore (caveat coming)…please seek professional advice before entering into any planning or drafting your Will.
Who needs to pay Inheritance Tax?
First to note is that IHT is payable on the value of the worldwide estate at death for UK domiciled individuals or “deemed” UK domiciles. This is the case whether you live here or not. For non-UK domiciles, IHT is payable on UK situs assets only, again, whether you live here or not (for instance, UK land and property).
I won’t explain domicile in full here as that’s an article in itself but, broadly, your domicile is where you or your father was born. That is unless you were born here but you have assumed a domicile of choice elsewhere. It is usually where someone has left the UK for good with no intention of returning and has no remaining assets in the UK, or any personal or business ties to the UK. This is difficult to achieve in reality and therefore, if in doubt, check as it’s very important to know so that you are aware of what your potential exposure to the tax is.
When is it due?
When you die, but it can also be payable during lifetime if you make a “chargeable lifetime transfer” such as transferring assets to a trust. See below.
Can my Will alter how much I pay and when?
Yes! The way that your Will is drafted also determines what IHT you pay and when, so it’s equally important to get a tax-efficient Will drafted and take advice to minimise any exposure to IHT. Nobody likes surprises where tax is concerned.
When it’s charged on death;
IHT is charged on the market value of your estate owned at the date of your death, plus any gifts you’ve made in the last seven years unless those gifts attract an exemption, less any allowable liabilities. Before IHT is calculated, a deduction is made for the available “nil rate band” and any IHT reliefs available. The rate of tax charged is 40% but is reduced to 36% if 10% of your net estate is left to charity. Different rates can also apply to the gifts made in the previous seven years. See below for more detail.
So what is the nil rate band?
This is the amount that you are permitted to own before paying IHT and is deducted from the value of your estate. The basic nil rate band is £325,000 per person.
However, if your gross estate is £2m or less, and you leave your main home to direct descendants, you will also be able to claim the “residence nil rate band”, which can be £175,000, giving an exemption of £500,000.
So, for example, if you had chargeable assets of £100k plus a house worth £400k and left your house to a direct descendent, you would be able to deduct a total of £325k+£175k=£500k from the estate, meaning that no IHT would be due.
Other exemptions on death
Assets left to your spouse or civil partner are exempt. In addition, any nil rate band or residence nil rate band not used on first death by your spouse can be transferred and used by the surviving spouse. So, in plain English, if this is the case, a married couple or those in a civil partnership with a combined estate of £2m or less leaving their home to direct descendants can have a total of £1m of assets before IHT is payable.
Note that if the estate is over £2m, the additional residence nil rate band is withdrawn by £1 for every £2 over £2m so an estate of £2,350,000 would not be able to claim the residence nil rate band – but planning can mean this is still available. In addition, if, on first death, the assets owned at that time are less than £2m but, on second death, they would be more (due to inheriting assets from the deceased spouse previously), planning can be undertaken on first death to make sure the first £175,000 is not lost.
Other reliefs
Business Property Relief/Agricultural Property Relief
Both of these reliefs can exempt up to 100% of their value from IHT. So if you have a trading business, trading company shares or a working farm, for instance, their value could escape IHT completely. The reliefs don’t apply to certain businesses such as land and property based “businesses” (other than property development), nor listed shares on the main markets and there are rules that can restrict the relief.
Therefore, if you own an asset that you think could qualify for either of these reliefs, seek advice to ensure there is nothing that could mean it’s not actually due, or that the relief could be restricted as there are usually ways to plan around this.
Gifts out of excess income
If you make regular gifts of cash and these are from income that isn’t spent (and therefore the capital value of your estate doesn’t decrease), these gifts will be immediately exempt from IHT if you die.
Annual gifts
You are allowed to make certain other gifts that are exempt from IHT if you die. These are;
- £3,000 per annum to anyone (and the previous year’s allowance can be brought forward and used the following year).
- Multiple £250 gifts to different people.
- £5,000 to a child in contemplation of marriage (or £2,500 to a grandchild or £1,000 to any other person).
Note that if an asset is given instead of cash, there may be Capital Gains Tax consequences so, again, seek advice.
Gifts to charity
Gifts to charity in your Will are exempt from IHT and also other gifts of national heritage assets (both are also exempt if given during lifetime too – and from Capital Gains Tax on disposal).
When does a gift made during lifetime become subject to IHT on death?
If you die within seven years of making the gift and the gifts don’t fall within any of the reliefs above, their value at the date of gift will be added into the death estate to calculate the IHT due. These gifts are known as “Potentially Exempt Transfers” (known as “PETs”) when they are made. “Potential” because you need to survive seven years for them to be exempt. However, after year three from the date of the gift to year seven, the IHT due on the gifts tapers from 40% down to 0% in year seven. So your estate could pay IHT at several different rates depending on how old the “failed” PETs are.
What is a chargeable lifetime transfer where IHT could be due during lifetime?
This is where it gets a bit more complicated! This is a transfer of assets or cash to a trust set up during lifetime. Trusts are useful for passing on assets in a controlled and tax-efficient way and the rules broadly work as follows;
During lifetime, if no other chargeable lifetime transfers have been made in the previous seven years, then £325k of “chargeable” assets can be transferred to trust per person without a lifetime IHT charge. You’ll note that I said “chargeable” assets. This is because the first £3,000 could be exempt if the annual allowance mentioned above hadn’t been used. In addition, if assets qualifying for another relief mentioned above such as BPR or APR are transferred, there is no limit on the value of transfer because the reliefs will wipe out any value subject to tax.
Any transfer in excess of the available nil rate band will suffer a lifetime IHT liability of 20% at the time the trust is set up and, if the person setting up the trust dies within seven years of set up, the value of the gift would be included in the estate at date of death. The calculation then becomes too complex to cover here as it then depends on other gifts made and, if the original transfer qualified for a relief at the time of transfer, whether the assets transferred (or replacement assets if the original assets transferred have been subsequently replaced with different qualifying assets) would still qualify for the relief at the date of death. However, note that if 20% tax was payable, it’s given as a credit against the IHT due at date of death.
In summary, this is how someone’s IHT liability may be calculated:
The market value of all assets at date of death + gifts made in the last seven years which are PETs + any chargeable lifetime transfers made in the last seven years.
Deduct any allowable liabilities they have (note there are specific rules for how some liabilities are deducted in the calculation).
Deduct any reliefs available; the nil rate band, residence nil rate band, BPR and APR.
Apply the appropriate rate of tax to the remaining value; 40% ordinary rate, 36% if the required amount is left to charity and the rate applicable to failed PETs depending on how old the gifts are or deduct the 20% tax already paid if the previous transfer to trust becomes chargeable.
I hope the above has been a helpful summary of the basic current rules. Please note that this is oversimplified for the purposes of illustrating the basic rules, so please do take advice. There are many ways that you can plan to reduce or wipe out an IHT liability, and tax-efficient Will drafting as mentioned previously is important. If you would like help, please get in touch with our expert Private Client team or call 0333 123 7171.
