Inheritance tax - Application and calculations

Learning Outcomes

This article outlines the application and calculation of Inheritance Tax (IHT) in England and Wales for SQE1, including:

• identifying transfers on death and relevant lifetime transfers (PETs and CLTs) that are chargeable or exempt;
• valuing the death estate, deducting liabilities, and applying exemptions and reliefs in the correct order before nil-rate bands;
• applying the standard nil-rate band and residence nil-rate band, including transferable unused percentages, the interaction with qualifying residential interests, and tapering where the estate exceeds £2 million;
• recognising when Business Property Relief and Agricultural Property Relief are available, the level of relief (50% or 100%), and how they affect the taxable estate;
• applying the seven-year rule and cumulation of lifetime transfers, including the ordering of PETs and CLTs when allocating the nil-rate band;
• calculating tax on failed PETs and CLTs, including taper relief bands, allocation of liability between donees and the personal representatives, and credit for lifetime tax;
• identifying gifts with reservation of benefit and explaining how they are brought back into the death estate, particularly in common exam scenarios involving the family home;
• applying the charity exemption and determining when the 10% test is satisfied so that the 36% reduced rate applies to the taxable estate.

SQE1 Syllabus

For SQE1, you are required to understand the application and calculation of Inheritance Tax (IHT) from a practical viewpoint, including the identification of chargeable transfers, calculation of IHT liabilities on death estates and failed lifetime gifts, and the application of relevant reliefs and exemptions in given scenarios. An appreciation of IHT is essential for advising clients on estate planning and administration, with a focus on the following syllabus points:

• Identifying chargeable transfers, including potentially exempt transfers (PETs) that become chargeable.
• Calculating the value of an estate for IHT purposes.
• Applying the nil-rate band (NRB) and residence nil-rate band (RNRB), including any transferable allowances.
• Calculating IHT payable on death, considering lifetime gifts made within seven years.
• Applying taper relief to failed PETs.
• Recognising and applying key reliefs, particularly Business Property Relief (BPR) and Agricultural Property Relief (APR).
• Understanding the main exemptions, such as spouse/civil partner and charity exemptions.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the standard rate of Inheritance Tax above the nil-rate band?
   1. 20%
   2. 36%
   3. 40%
   4. 45%
2. Which of the following lifetime gifts is most likely to be a Potentially Exempt Transfer (PET)?
   1. A gift into a discretionary trust.
   2. A gift to a registered charity.
   3. A gift from a parent to their adult child.
   4. A gift between spouses.
3. Business Property Relief (BPR) offers 100% relief on which of the following assets, assuming the qualifying conditions are met?
   1. Shares in a listed company where the deceased had control.
   2. An interest in an unincorporated business.
   3. Land used by a partnership where the deceased was a partner.
   4. Shares in an unlisted investment company.
4. How long must a donor survive after making a PET for it to become fully exempt from IHT?
   1. 3 years
   2. 5 years
   3. 7 years
   4. 14 years

Introduction

Inheritance Tax (IHT) is levied on the value of an individual's estate upon their death and on certain gifts made during their lifetime. Understanding its calculation, applicable thresholds, reliefs, and exemptions is essential for legal practitioners advising on wills, trusts, and estate administration. This article outlines the fundamental principles of IHT application and calculation relevant for the SQE1 assessment.

IHT is primarily charged on the value of the deceased's estate that exceeds the available nil-rate band thresholds. Lifetime gifts can also impact the calculation, particularly if made within seven years prior to death. Order matters: exemptions and reliefs are applied before nil-rate bands, and earlier lifetime transfers use the available NRB before the death estate.

Key Term: Estate
For IHT purposes, the estate comprises all the property to which the deceased was beneficially entitled immediately before death, less allowable debts and funeral expenses.

Chargeable Transfers

IHT is charged on the value transferred by a chargeable transfer. The two main types of chargeable transfer are transfers made on death and certain lifetime transfers.

Transfers on Death

The most significant chargeable transfer occurs on death. The value transferred is the value of the deceased's estate immediately before death. No Capital Gains Tax (CGT) is charged on death; instead assets are rebased to market value for the personal representatives. However, IHT may apply to the estate subject to exemptions, reliefs and nil-rate bands.

Lifetime Transfers

Certain gifts made during a person's lifetime can also be subject to IHT. For SQE1 purposes, the most important type is the Potentially Exempt Transfer (PET).

Key Term: Potentially Exempt Transfer (PET)
A lifetime gift made by one individual to another individual (or into certain types of trust for disabled beneficiaries). It is potentially exempt because it only becomes chargeable to IHT if the donor dies within seven years of making the gift.

Gifts between spouses or civil partners, gifts to charities, and gifts covered by annual exemptions are typically exempt from IHT regardless of timing.

Key Term: Chargeable Lifetime Transfer (CLT)
A lifetime transfer that is immediately chargeable to IHT (though often at a lower rate of 20% if tax is paid by the donor). The most common example is a gift into most types of trust (excluding bare trusts or trusts for disabled beneficiaries). While relevant, PETs are the primary focus for lifetime gifts in SQE1.

When CLTs are made, IHT may be payable at the lifetime rate (normally 20%). If the donor dies within seven years, further tax may be due, computed using the death rate (40%) and giving credit for tax already paid on the CLT. The cumulation rules mean that earlier transfers within seven years use the NRB before later transfers and the death estate.

Key Term: Gifts with Reservation of Benefit (GWR)
A gift where the donor retains a benefit (e.g., gifting a house but continuing to live there rent‑free). Such property is treated as still within the donor’s estate for IHT on death unless full consideration is paid for the retained benefit.

GWR rules are common exam traps. If the donor makes a gift but reserves any benefit, the gifted asset is treated as part of the death estate. Paying a full market rent may remove the reservation, but care is required.

Calculating IHT on Death

The calculation involves several steps: identifying the assets, valuing the estate, applying exemptions and reliefs, deducting nil-rate bands, and calculating the tax due.

Step 1: Identify and Value the Death Estate

Determine all assets owned by the deceased immediately before death (e.g., property, bank accounts, investments, personal possessions) and deduct allowable liabilities (e.g., mortgages, unpaid bills, reasonable funeral expenses). Anti-avoidance rules restrict deduction of certain debts, such as loans used to acquire excluded property or to finance assets attracting reliefs; ensure the debt is genuine and lawfully enforceable.

Assets held in trust may be relevant. For example, life insurance written in trust is generally outside the estate (proceeds pass to trustees for beneficiaries), whereas assets subject to GWR are brought back into the estate.

Step 2: Deduct Exemptions and Reliefs

Certain transfers are exempt or benefit from reliefs, reducing the value subject to tax.

• Spouse/Civil Partner Exemption: Transfers between spouses or civil partners (domiciled in the UK) are fully exempt. If the recipient spouse/civil partner is non-UK domiciled, a limit may apply to the exemption for lifetime transfers; consider domicile only if relevant facts are provided.
• Charity Exemption: Gifts to qualifying UK charities are fully exempt. If at least 10% of the net baseline amount is left to charity, the IHT rate on the remaining taxable estate may be reduced from 40% to 36% (see charity rate calculation below).
• Business Property Relief (BPR): Reduces the value of relevant business property.
  • 100% Relief: Typically applies to interests in an unincorporated business, partnership interests, and shares in unlisted trading companies held for at least two years.
  • 50% Relief: Typically applies to controlling shareholdings in listed trading companies, and certain assets (land/buildings/machinery) owned by the deceased but used in their company or partnership where qualifying conditions are met and held for at least two years.
  • Investment businesses do not qualify. Hold-over periods and replacements may be relevant for lifetime transfers, but the key point is that qualifying trading assets can be largely removed from charge.
• Agricultural Property Relief (APR): Reduces the agricultural value of qualifying agricultural property. APR can provide 100% or 50% relief depending on ownership/occupation periods (commonly two years if owner-occupied, seven years if let), and the property must have an agricultural use.

Key Term: Business Property Relief (BPR)
A relief that reduces the value of qualifying business assets for IHT purposes, potentially by 100% or 50%, provided ownership conditions are met.

If both BPR and APR could apply to an asset, APR is usually applied first. RNRB tapering is assessed by reference to the estate value before deducting BPR/APR; do not reduce the estate for the RNRB taper calculation by these reliefs.

Step 3: Apply the Nil-Rate Bands

After deducting exemptions and reliefs, the remaining value is potentially subject to tax, but only on the amount exceeding the available nil-rate bands.

• Nil-Rate Band (NRB): Every individual has an NRB, currently £325,000. This amount can be transferred on death tax-free. Any unused NRB from a previously deceased spouse or civil partner can be transferred to the surviving spouse/civil partner. Transferability is by percentage of unused NRB, not a fixed sum, so the survivor’s NRB increases by the same proportion unused by the first to die.

Key Term: Nil-Rate Band (NRB)
The threshold up to which an estate is not charged to IHT. Currently £325,000 per individual.

• Residence Nil-Rate Band (RNRB): An additional allowance available if a main residence is passed to direct descendants (children, grandchildren, stepchildren, adopted and looked-after children). Currently £175,000 per individual. Like the NRB, any unused RNRB (expressed as a percentage) can be transferred from a previously deceased spouse or civil partner. The RNRB is limited to the value of the qualifying residential interest actually inherited, and is tapered for estates valued over £2 million.

Key Term: Residence Nil-Rate Band (RNRB)
An additional IHT allowance applicable when a qualifying residential interest is passed to direct descendants. Currently £175,000 per individual, subject to estate value tapering.

Qualifying “inheritance" for RNRB purposes includes outright gifts and certain trust interests (for example, an immediate post-death interest for a direct descendant or a bare trust). Downsizing relief may be available where the deceased sold or downsized their main residence but left equivalent assets to direct descendants; calculation is fact‑sensitive.

The taper reduces the RNRB by £1 for every £2 that the net value of the estate exceeds £2 million. The “estate value” for taper is measured before deducting BPR/APR or the NRB; be precise about the order.

Step 4: Consider Lifetime Gifts

Lifetime gifts made within the seven years before death must be considered. PETs made within this period become chargeable transfers and use up the NRB before the death estate. CLTs made within seven years also use up the NRB, and may have had lifetime tax charged at 20%.

• Seven-Year Rule: If the donor survives seven years after making a PET, it becomes fully exempt. If they die within seven years, the PET becomes chargeable and utilises the NRB available at death. Earlier gifts use the NRB first.
• Cumulation: You must aggregate all chargeable transfers in the seven years preceding death in chronological order. Earlier transfers reduce the available NRB for later transfers and, ultimately, for the death estate.
• Credit for Lifetime Tax on CLTs: Where CLTs within seven years of death have already borne lifetime tax, any additional tax due on death is computed at 40% with credit for lifetime tax paid.
• Taper Relief: If IHT becomes payable on a PET (or CLT) because the donor died between 3 and 7 years after making the gift, the tax payable on that gift (not the value of the gift itself) is reduced:
  • 3‑4 years: 20% reduction
  • 4‑5 years: 40% reduction
  • 5‑6 years: 60% reduction
  • 6‑7 years: 80% reduction

Key Term: Taper Relief
A relief that reduces the amount of IHT payable on a lifetime gift (PET or CLT) if the donor dies between 3 and 7 years after making it.

Liability to pay IHT on lifetime transfers generally falls on the recipient of the gift (donee) or trustees (for CLTs). If the recipient cannot pay, HMRC can seek payment from the personal representatives; always check the statutory apportionment in complex cases.

Worked Example 1.1

David died in May 2023 leaving an estate valued at £700,000. His wife predeceased him, having used none of her NRB or RNRB. David left his entire estate, including his main residence worth £300,000, to his son. David made no lifetime gifts.

Answer:

1. Estate Value: £700,000
2. Available NRB: £325,000 (David's) + £325,000 (Transferred) = £650,000
3. Available RNRB: £175,000 (David's) + £175,000 (Transferred) = £350,000. However, RNRB is limited to the value of the residence passed to direct descendants (£300,000).
4. Total Allowances: £650,000 (NRB) + £300,000 (RNRB) = £950,000
5. Taxable Estate: £700,000 - £950,000 = £0 (as allowances exceed estate value)
6. IHT Payable: £0

Worked Example 1.2

Sarah made a PET of £400,000 to her daughter in June 2018. Sarah died in August 2023 (just over 5 years later). Her death estate is valued at £500,000. Assume the NRB is £325,000.

Answer:

Tax on the PET:

1. Value of PET: £400,000
2. Less NRB: (£325,000)
3. Taxable Amount: £75,000
4. IHT @ 40%: £30,000
5. Taper Relief (5-6 years = 60% reduction): 60% of £30,000 = £18,000
6. IHT on PET: £30,000 - £18,000 = £12,000 (payable by the daughter)

Tax on the Death Estate:

1. Value of Estate: £500,000
2. NRB Available: £325,000 (NRB at death) - £325,000 (used by PET) = £0
3. Taxable Estate: £500,000
4. IHT @ 40%: £200,000 (payable by the estate)

Total IHT: £12,000 + £200,000 = £212,000

Worked Example 1.3

Richard died with a net estate of £2,300,000 in July 2024. He leaves his main residence (worth £500,000) to his two children, and the residue to his spouse. He has his own full NRB and RNRB available; no transferable allowances. No lifetime gifts.

Answer:

1. Estate value for RNRB taper: £2,300,000 (before BPR/APR or NRB)
2. RNRB basic: £175,000
3. Taper reduction: Excess over £2,000,000 = £300,000; taper at £1 per £2 excess = £150,000; tapered RNRB = £175,000 − £150,000 = £25,000 (limited also by value of residence passing to descendants; here £500,000 so £25,000 applies)
4. NRB: £325,000 (applies to residue if needed after exemptions/reliefs)
5. Apply exemptions: Residence to children qualifies for RNRB (£25,000 band effect only) but is not exempt; residue to spouse is fully exempt.
6. Chargeable amount: The residence falls into charge but is reduced by RNRB of £25,000; therefore taxable amount on residence = £500,000 − £25,000 = £475,000. NRB is available and is set against the chargeable amount: £475,000 − £325,000 = £150,000 taxable @ 40% = £60,000.

IHT due: £60,000. Note the spouse exemption shelters the residue entirely, and the RNRB is tapered because the estate exceeds £2 million.

Worked Example 1.4

Hannah made two PETs: £200,000 to her son on 1 June 2019, and £250,000 to her daughter on 1 June 2021. She dies on 1 August 2023 with a death estate of £600,000. Assume NRB is £325,000. No RNRB applies.

Answer:

1. Order gifts chronologically: 2019 PET (£200,000), then 2021 PET (£250,000).
2. Apply NRB to earliest PET first: 2019 PET uses £200,000 of NRB leaving £125,000.
3. Apply remaining NRB to second PET: 2021 PET uses remaining £125,000; taxable PET portion = £250,000 − £125,000 = £125,000 @ 40% = £50,000.
4. Taper relief for 2021 PET: Death between 2 and 3 years? No, death at 2 years and 2 months yields 3‑4 year band does not apply; correct band is 2‑3 years which does not give taper relief (taper starts after 3 years), so no reduction. Tax on 2021 PET = £50,000 (donee pays).
5. NRB remaining for death estate: £325,000 − £200,000 − £125,000 = £0.
6. Taxable death estate: £600,000 @ 40% = £240,000 (estate pays).

Total IHT = £50,000 (on 2021 PET) + £240,000 (estate) = £290,000.

Worked Example 1.5

Maya dies in October 2024 with a net estate of £1,200,000 after debts and funeral expenses. She leaves £150,000 to charity and the residue to her nephews. No lifetime gifts; no RNRB (no residence). Determine if the reduced 36% rate applies and calculate IHT.

Answer:

1. Baseline amount: Determine the net estate after deducting funeral expenses and debts, but before deducting charitable legacies and applying NRB. Here baseline amount = £1,200,000.
2. Ten per cent test: Charity legacy is £150,000; 10% of baseline amount is £120,000; since £150,000 ≥ £120,000, the 36% rate applies to the taxable part of the estate after bands.
3. Apply NRB: NRB £325,000 reduces taxable estate. Chargeable estate before rate = baseline − NRB − charity gift = £1,200,000 − £325,000 − £150,000 = £725,000.
4. Apply reduced rate: IHT @ 36% on £725,000 = £261,000.

The charitable legacy both qualifies for exemption and triggers the reduced rate on the taxable residue.

Worked Example 1.6

Jo gifts her home (worth £500,000) to her daughter in 2020 but continues to live in it rent‑free. Jo dies in 2025. What are the IHT consequences?

Answer:

The gift is caught by GWR rules because Jo reserved a benefit (rent‑free occupation). The property is treated as part of Jo’s estate at death at its then market value (subject to NRB/RNRB and any exemptions). The prior gift is ignored as a PET for IHT, but CGT on death is not charged; the property value is rebased for the estate administration.

Step 5: Calculate Tax Liability

Any value of the estate exceeding the available NRB and RNRB is taxed at the standard rate of 40% (or potentially 36% if the 10% charity donation rule applies). Always apply bands after exemptions and reliefs. Where CLTs are present, compute additional tax due by comparing the death rate and lifetime tax already paid.

Other Exemptions

Besides the spouse/civil partner and charity exemptions, other lifetime exemptions can reduce the value of gifts subject to the seven-year rule:

• Annual Exemption: Individuals can gift up to £3,000 per tax year free of IHT. Any unused portion can be carried forward one year only.
• Small Gifts Exemption: Gifts up to £250 per recipient per tax year are exempt, provided the recipient does not also benefit from the annual exemption from the same donor.
• Gifts in Consideration of Marriage/Civil Partnership: Exempt up to certain limits depending on the relationship between the donor and the recipient (e.g., £5,000 from a parent).
• Normal Expenditure Out of Income: Regular gifts made from surplus income that do not affect the donor's standard of living can be exempt. Document the pattern and affordability; HMRC expects evidence of normality and that the gifts are genuinely out of income.

Certain maintenance payments (for example, to a former spouse or to a minor) may be exempt. Where facts suggest possible exemptions, apply them before reliefs and bands.

Revision Tip

Remember that taper relief reduces the tax payable on a failed PET, not the value of the gift charged to tax. The full value of the gift still uses up the NRB first.

Payment of IHT

IHT on the death estate is generally payable within six months from the end of the month of death. Interest accrues on late payments. IHT on certain assets, like land and buildings, may be paid in instalments over ten years. IHT on lifetime transfers that become chargeable due to death within seven years is typically payable by the recipient of the gift.

In terms of liability:

• Donees and trustees are primarily liable for tax on lifetime transfers (with statutory apportionment rules).
• Personal representatives are liable for tax on the death estate and may be pursued if donees default.
• For property qualifying for instalments (e.g., real property or shares in certain companies), ensure instalment options are considered and interest implications are understood.

Exam Warning

Be careful when applying transferable nil-rate bands. Ensure you check if the previously deceased spouse/civil partner used any of their NRB or RNRB. Also, note the tapering rules for the RNRB on estates over £2 million.

Further Practical Points

• Order of application: Exemptions and reliefs first, then NRB and RNRB, then rates.
• CGT interactions: No CGT on death; assets pass to personal representatives at market value. Where business interests are present, BPR can mitigate IHT significantly, while CGT may arise later when the beneficiaries dispose of assets.
• Trusts: Lifetime transfers into discretionary trusts are CLTs. Such trusts are within the “relevant property regime” (with periodic and exit charges), but for IHT on death you mainly need to aggregate CLTs within seven years and give credit for lifetime tax.

Key Point Checklist

This article has covered the following key knowledge points:

• IHT is charged on the value of the deceased's estate and certain lifetime gifts (PETs) made within seven years of death.
• The main thresholds are the Nil-Rate Band (NRB) of £325,000 and the Residence Nil-Rate Band (RNRB) of £175,000.
• Unused NRB and RNRB can often be transferred from a deceased spouse or civil partner (by percentage).
• PETs become chargeable if the donor dies within seven years, using up the NRB first; CLTs may have lifetime tax credit and can attract further tax on death.
• Taper relief can reduce the tax payable on failed PETs made between 3 and 7 years before death.
• Key reliefs include Business Property Relief (BPR) and Agricultural Property Relief (APR).
• Key exemptions include spouse/civil partner and charity exemptions; a 36% reduced rate may apply if the 10% charity test is met.
• The standard rate of IHT is 40%; tax may be paid by instalments for certain assets.
• Gifts with reservation of benefit are treated as part of the death estate.

Key Terms and Concepts

• Estate
• Potentially Exempt Transfer (PET)
• Chargeable Lifetime Transfer (CLT)
• Gifts with Reservation of Benefit (GWR)
• Business Property Relief (BPR)
• Nil-Rate Band (NRB)
• Residence Nil-Rate Band (RNRB)
• Taper Relief