Making gifts of value during an individual’s lifetime is a tried and trusted way of reducing the exposure to IHT. Many people are aware of the so-called "seven-year rule", which provides that a potentially exempt transfer (PET) becomes fully exempt as long as the person making the gift is still alive on the seventh anniversary of the date the gift was made. Of these people, some will be aware that 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 make large gifts later in life without taking professional advice in the belief that, if they survive at least three years, there will at least get some IHT relief. However, in practice the rules are not that simple.
The partial relief is of course taper relief. This provides that where 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 of course the PET becomes fully exempt.
There are a few misconceptions about the relief. Firstly, 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.
A further misconception stems from a lack of understanding of the underlying legislation behind the relief. This is perhaps best illustrated using a simple case study.
John passed away recently. He was never married but had three children. He owned no property but had a reasonably-sized investment portfolio including listed shares and cash. Just over six years ago, John 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. Essentially, John’s eldest child was getting their inheritance in John’s lifetime. The remaining amounts would be split between the other two children upon John’s death. John made no other gifts during his lifetime.
As John 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. In order for there to be a taper relief deduction, there has to 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.
Of course, purely from an IHT perspective an easy answer to the problem would have been for John 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 John’s.
A potential solution would have been for John 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 serves to show how what is a relatively simple aspect of IHT legislation can still be far more complicated than it appears on the surface and taking advice prior to acting is essential.