Inheritance Tax on lifetime transfers and transfers on death...

Learning Outcomes

This article explains how to calculate Inheritance Tax (IHT) on lifetime transfers and on death, focusing on the distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs), the operation of the nil-rate band and residence nil-rate band (including tapering above £2 million and downsizing rules), and the main exemptions and reliefs that can reduce or eliminate IHT. It explains how previous gifts affect the cumulative total, how to order PETs and LCTs chronologically, and how that ordering drives the availability of nil-rate band and residence nil-rate band on death. It also covers taper relief on gifts, recalculation and credit for lifetime tax on LCTs when death occurs within seven years, grossing up where the donor pays lifetime IHT, apportionment by estate rate and the instalment option for qualifying assets, and the reduced 36% charity rate and quick succession relief. Finally, it analyzes the distinction between liability to account and the burden of tax for PRs, trustees and donees, and applies these rules systematically to SQE1-style problem questions so you can structure accurate, time-efficient IHT computations under exam conditions.

SQE1 Syllabus

For SQE1, you are required to understand how IHT applies to lifetime transfers and transfers on death, and how to calculate the resulting tax liability, with a focus on the following syllabus points:

• the distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs)
• the effect of the nil-rate band and residence nil-rate band on IHT calculations
• the application of main exemptions and reliefs (including spouse exemption, annual exemption, normal expenditure out of income, business and agricultural relief)
• how to calculate IHT on death, including the impact of previous gifts within seven years
• the operation of taper relief and gifts with reservation of benefit
• credit for lifetime tax already paid on LCTs if the donor dies within seven years
• grossing up when the donor pays lifetime IHT on an LCT
• the reduced 36% charity rate when at least 10% of the baseline amount passes to charity
• quick succession relief where assets suffer IHT twice within five years
• liability vs burden of IHT on death, including PRs, trustees and transferees
• apportionment of tax by estate rate and the instalment option for certain assets
• the correct order and method for calculating IHT liability in SQE1-style questions

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 main difference between a potentially exempt transfer (PET) and a lifetime chargeable transfer (LCT) for IHT purposes?
2. How does a gift made within seven years of death affect the nil-rate band available to the estate?
3. What is the effect of the spouse exemption and annual exemption on IHT calculations?
4. When does taper relief apply, and how does it affect the IHT payable on a lifetime gift?

Introduction

Inheritance Tax (IHT) is a tax on the transfer of assets, whether during a person’s lifetime or on death. For SQE1, you must be able to distinguish between the types of transfers, apply the correct exemptions and reliefs, and calculate the IHT liability in a variety of scenarios. This article explains the key principles and steps for calculating IHT on both lifetime transfers and transfers on death.

IHT is a cumulative tax. Previous transfers are looked at on a seven-year rolling basis and can affect the nil-rate band (NRB) available, the rate at which lifetime transfers are taxed, and the calculation of tax on death. PETs are exempt when made but can “fail” and become chargeable if the donor dies within seven years. LCTs are chargeable when made, and if the donor dies within seven years they are recalculated at death rates, with credit given for lifetime tax already paid.

Key Term: potentially exempt transfer (PET)
A gift made by an individual to another individual (or to a qualifying trust for disabled persons) that is exempt from IHT if the donor survives seven years, but becomes chargeable if the donor dies within that period.

Key Term: lifetime chargeable transfer (LCT)
A transfer of value (usually to a trust or, rarely, to a company) that is immediately chargeable to IHT at the lifetime rate on the value above available NRB, with a further charge if the donor dies within seven years.

Types of Lifetime Transfers: PETs and LCTs

IHT can arise on transfers made during a person’s lifetime or on death. The rules differ depending on the type of transfer.

Potentially Exempt Transfers (PETs)

A PET is a gift made by an individual to another individual outright. It is not taxed at the time of the gift. If the donor survives for seven years after making the PET, the gift is fully exempt and falls out of account. If the donor dies within seven years, the PET becomes chargeable: it uses the NRB and, if it exceeds the available NRB, tax is payable on the excess at the death rate. Importantly, taper relief can reduce the tax payable on the failed PET if the donor survived more than three years from the date of the gift, but it does not reduce the value transferred and does not “free up” NRB.

Certain trusts for disabled beneficiaries are treated as PETs if they meet specific statutory conditions (discretionary in form but qualifying under Finance Act 2005, Sch 1A, and IHTA 1984, s 89).

Lifetime Chargeable Transfers (LCTs)

An LCT is chargeable when made. The most common example is a transfer into a discretionary trust (or any post-2006 lifetime settlement that is within the relevant property regime). If in a tax year the cumulative chargeable transfers exceed the NRB, the excess is taxed at 20% if the trustees pay, or at an effective 25% if the donor pays due to the grossing up mechanism.

Key Term: grossing up (lifetime LCT)
Where the donor pays lifetime IHT on an LCT, the “value transferred” includes the tax paid. The transfer must be grossed up so that, after tax at 20%, the trustees receive the intended net amount. The effective rate is 25% on the net amount paid.

If the donor dies within seven years of an LCT, the tax on that transfer is recalculated at 40% (death rate), taper relief may reduce the recalculated tax depending on the time elapsed, and credit is given for any lifetime tax already paid. If the recalculated tax after taper is lower than the lifetime tax already paid, there is no refund.

The Nil-Rate Band and Residence Nil-Rate Band

The NRB is the threshold below which IHT is charged at 0%. The standard NRB is currently £325,000, scheduled to be frozen until 5 April 2026. Chargeable transfers in the seven years before death use up the NRB in chronological order, starting with the earliest transfer within the seven-year window. This reduces the NRB available to set against the death estate.

Key Term: nil-rate band (NRB)
The threshold (currently £325,000) below which IHT is charged at 0%. Used up by chargeable transfers within seven years before death; transferable between spouses by percentage.

The NRB is transferable between spouses or civil partners. On the second death, the unused percentage of the first spouse’s NRB can be claimed and applied to the second spouse’s estate, potentially allowing up to two NRBs.

Key Term: residence nil-rate band (RNRB)
An additional IHT allowance (currently up to £175,000) for estates where a home (or equivalent value under downsizing rules) is “closely inherited” by direct descendants. It tapers by £1 for every £2 that the net estate exceeds £2 million and is transferable by percentage between spouses.

The RNRB applies only to the death estate; it cannot be used against lifetime transfers. Key conditions:

• the property must be the deceased’s main residence (or downsizing substitution) and pass to lineal descendants (or their spouses/civil partners)
• the RNRB reduces by £1 for every £2 the net estate exceeds £2 million (the “taper threshold”)
• if the residence was sold or downsized after 8 July 2015, a downsizing addition may be available, capped by the value left to direct descendants

Main Exemptions and Reliefs

Several exemptions and reliefs can reduce or eliminate IHT liability:

Key Term: spouse exemption
Transfers between spouses or civil partners are exempt from IHT. The exemption is unlimited if the recipient spouse/civil partner is UK-domiciled. If the recipient is non-UK domiciled, the exemption is capped (currently aligned to the NRB) unless an election is made to be treated as UK-domiciled for IHT.

Key Term: annual exemption
Each individual can give away up to £3,000 per tax year free of IHT. Unused annual exemption can be carried forward one tax year. The current year’s exemption must be used first. The small gifts exemption (£250 per donee per tax year) cannot be combined with the annual exemption for the same donee.

Key Term: normal expenditure out of income
A lifetime exemption for regular gifts made out of the donor’s surplus income, as part of normal expenditure, without reducing the donor’s standard of living. There is no monetary cap, but the donor must demonstrate regularity, that gifts came from income, and that adequate income remained.

Key Term: business relief
Relief of 50% or 100% from IHT on qualifying business assets (e.g., interests in a trading business, shares in unlisted trading companies). Relief depends on the asset type and conditions, such as minimum holding periods.

Key Term: agricultural relief
Relief of up to 100% from IHT on qualifying agricultural property (e.g., farmland, farm buildings) subject to occupation/use tests and certain conditions.

Other important exemptions include:

• small gifts exemption (£250 per person per tax year, not combinable with annual exemption to the same donee)
• gifts in consideration of marriage/civil partnership (statutory limits apply: typically up to £5,000 by a parent, £2,500 by a grandparent, £1,000 by others)
• gifts to charities and certain political parties (fully exempt)
• qualifying settlements for disabled beneficiaries

If 10% or more of the net estate (the “baseline amount”) passes to charity on death, the rate of IHT on the chargeable part of the estate falls from 40% to 36%.

Key Term: instalment option
For certain assets (e.g., land, a business or interest in a business, controlling holdings, and certain unquoted shareholdings), IHT attributable to those assets can be paid in up to 10 equal annual instalments. Interest rules differ: for shares/business/agricultural land, interest accrues per instalment; for other land, interest accrues on outstanding IHT after the first instalment.

Key Term: estate rate
The average tax rate on the estate. It is used to apportion the total IHT payable proportionately to items of property, including those where instalment options or special liability rules apply.

Calculating IHT on Death

When a person dies, IHT is charged on the value of their estate, plus certain gifts made within the previous seven years. The calculation involves several steps:

• Identify chargeable transfers (PETs that fail and LCTs) in the seven years before death, after deducting available exemptions and reliefs.
• Apply the NRB, using it up against the earliest transfers first, to determine what remains for the estate.
• Consider transferable NRB and any available RNRB (including downsizing and tapering).
• Calculate IHT at 40% on the value above the available bands; apply the reduced 36% rate if the charity condition is met (10% of the baseline amount).
• Apply taper relief to chargeable transfers made more than three years before death; remember it reduces tax, not value or NRB usage.
• Recalculate LCTs at death rate and give credit for lifetime tax already paid; no refunds if the recalculated tax after taper is lower than the lifetime tax.
• Apportion tax across assets using the estate rate as needed, and identify any instalment options.
• Apply exemptions and reliefs to the estate and earlier gifts, including business/agricultural relief.
• Determine liability to pay (PRs, trustees, donees) and the burden of tax in accordance with will terms and statute.

Worked Example 1.1

Aisha made a PET of £200,000 to her son five years before her death, and a gift of £100,000 to a discretionary trust (an LCT) three years before her death. At death, her estate is worth £500,000. She made no other gifts.

Question: How is the IHT liability calculated?

Answer:
The PET and LCT use up £300,000 of the NRB, leaving £25,000 NRB for the estate (£325,000 − £300,000). The first £25,000 of the estate is taxed at 0%, and the remaining £475,000 is taxed at 40%. The LCT is recalculated at the death rate (40%), with credit for any lifetime tax paid (20% at the time of the transfer, or 25% if the donor paid). As the LCT occurred three years before death, taper relief does not reduce the tax (0–3 years: 100% of full tax). Business or agricultural relief is checked if relevant assets are present.

Cumulation and the seven-year look-back

The seven-year look-back is applied from the date of death for the death estate. For failed PETs, a separate cumulation period applies: you look back seven years from the date of the PET to see whether any LCT falls within that period to reduce NRB available to the PET. An LCT made more than seven years before death may still affect the NRB available to a failed PET if it falls within the PET’s cumulation window. By contrast, a PET made more than seven years before death is ignored entirely.

Worked Example 1.2

Ben made a PET of £100,000 to his daughter six years before death, and a PET of £150,000 to his son two years before death. His estate is worth £400,000. He made no other gifts.

Question: What is the IHT liability?

Answer:
The PETs total £250,000, using up that much of the NRB. The estate has £75,000 of NRB remaining (£325,000 − £250,000). The first £75,000 of the estate is taxed at 0%, and the remaining £325,000 is taxed at 40%. The PET to the daughter was made six years before death, so taper relief reduces the tax payable on that gift if it exceeds the available NRB (60% of full tax for gifts made 4–5 years before death; 40% for 5–6 years). Taper relief does not restore or increase NRB.

Worked Example 1.3

Clara leaves her business (qualifying for 100% business relief) worth £300,000 to her son, and the rest of her estate (£400,000) to her daughter. She made no gifts in the previous seven years.

Question: How does business relief affect the IHT calculation?

Answer:
The business is exempt from IHT due to 100% business relief. The NRB is applied to the rest of the estate (£400,000). If the NRB is £325,000, only £75,000 is taxed at 40%. Business relief reduces the taxable estate; verify qualifying conditions.

Worked Example 1.4

George transferred £381,000 into a discretionary trust (an LCT) on 1 May 2017. He had made no other lifetime gifts. He dies on 1 September 2020.

Question: Calculate the lifetime tax when made, and the further tax on death including taper relief and credit.

Answer:
Lifetime position: apply two annual exemptions (£3,000 × 2 = £6,000) if available, leaving £375,000. NRB £325,000 at 0%, balance £50,000 at 20% equals £10,000 (if trustees pay). On death within 3–4 years, the LCT is recalculated at 40% on £50,000, giving £20,000. Taper relief at 80% yields £16,000. Credit the £10,000 lifetime tax already paid; further tax due is £6,000. If George had paid the lifetime tax himself, lifetime tax would have been higher due to grossing up; credit is still given for the amount paid.

Worked Example 1.5

Harriet made an LCT of £340,000 more than six years but less than seven years before her death, using all of her NRB at that time. Her death estate is £130,000 with no reliefs or exemptions.

Question: How is tax on the LCT handled, and what happens to the estate?

Answer:
Recalculate tax at 40% on £340,000. Taper relief at 20% applies (6–7 years): the recalculated tax reduces to 20% of full tax. If lifetime tax paid exceeds the tapered death tax, there is no refund. Since the NRB was exhausted by the LCT, the entire death estate (£130,000) is taxed at 40%.

Worked Example 1.6

Nadia dies with a net estate (after debts and funeral, but before exemptions) of £900,000. She leaves her house worth £300,000 to her grandchildren and £100,000 to charity, with the residue to her children. No lifetime gifts were made.

Question: How do RNRB and the reduced charity rate apply?

Answer:
RNRB: Nadia’s home passes to lineal descendants; up to £175,000 RNRB can apply if available and not tapered (her estate is below £2 million). NRB of £325,000 plus RNRB of £175,000 gives £500,000 tax-free bands for the qualifying portions. Reduced rate: determine the baseline amount (net estate less NRB, reliefs other than charity exemption). If the charitable gift is at least 10% of that baseline amount, the rate on the chargeable estate reduces to 36%. Calculate the baseline, compare the £100,000 gift, and apply 36% to the chargeable portion if the 10% threshold is met.

Taper Relief

Taper relief reduces the IHT payable on chargeable transfers (PETs or LCTs) made more than three years before death. It does not reduce the value transferred, only the tax payable on the transfer. It does not apply to tax on the death estate itself.

Key Term: taper relief
A reduction in IHT payable on chargeable transfers made more than three years before death, based on the time elapsed. It reduces tax due on the gift but not the NRB used.

Gifts with Reservation of Benefit

If a donor gives away an asset but continues to benefit from it (e.g., continues to live in a gifted house rent-free), the asset is treated as remaining in their estate for IHT purposes. The donee is primarily liable for the tax attributable to that property; if unpaid 12 months after the end of the month of death, PRs become liable to the extent of assets they have or should have collected.

Key Term: gift with reservation of benefit
A gift where the donor retains a benefit from the asset, causing it to be included in their estate for IHT. Example: giving a house to a child but continuing to occupy it without paying market rent.

A reservation can be removed prospectively (e.g., donor begins to pay full market rent on a gifted home), at which point the gift may be treated as a PET from that date. Anti-avoidance rules are strict and aim to prevent double advantages.

Quick Succession Relief and Charity Rate

If property passes on death to a person and is charged to IHT, and that person dies within five years, quick succession relief (QSR) can reduce the IHT on the second death. The relief is based on the time between transfers and the net/gross ratio of the original taxed transfer.

Key Term: quick succession relief (QSR)
A reduction of IHT where property is charged twice within five years. Relief is a percentage of the tax borne on the earlier transfer (100%, 80%, 60%, 40%, or 20% depending on whether the second death occurs within 1, 2, 3, 4, or 5 years), adjusted by the net/gross ratio.

The reduced charity rate applies where at least 10% of the baseline amount passes to charity. Identify the baseline, test the 10% threshold, and, if met, apply 36% to the chargeable estate. This can increase net value to non-charitable beneficiaries compared to leaving a smaller charitable legacy and paying 40% on the remainder.

Liability vs Burden; Payment and Instalments

Liability concerns who HMRC can demand payment from; burden concerns who ultimately bears the tax economically. Statutory liability rules cannot be altered, but burdens can be shifted by will provisions.

• PRs are liable for IHT on the non-settled estate and certain property treated as part of the estate (e.g., joint assets passing by survivorship, gifts with reservation) if unpaid. PRs’ liability for tax on lifetime gifts arises if the tax remains unpaid 12 months after the end of the month of death and is limited to the value of assets they have received or should have received.
• Trustees are liable for tax attributable to settled property comprised in a settlement immediately before death (e.g., an IPDI/qualifying interest in possession treated as part of the deceased beneficiary’s estate).
• Transferees/donees are concurrently liable for tax on failed PETs and for additional tax on LCTs.

The basic rule is that IHT on death is due six months after the end of the month of death. However, any IHT due before grant must be paid to obtain the grant. Funding options include HMRC’s Direct Payment Scheme from bank accounts, beneficiary loans, or bank loans secured against estate assets. For instalment option property (land, business interests, certain shareholdings), IHT may be paid over up to 10 years, and the estate rate is used to apportion tax to those assets.

Key Term: estate rate
The proportionate rate of IHT across the estate. It allows PRs and trustees to attribute the tax to specific items (e.g., land eligible for instalments) in proportion to their value.

Key Term: instalment option
A statutory option to spread IHT attributable to certain assets over up to 10 annual instalments. Interest rules vary by asset type; eligibility includes land, controlling shareholdings, qualifying unquoted shareholdings, and business interests.

The Order of Calculating IHT

For SQE1, you must follow the correct order when calculating IHT:

1. List all chargeable transfers (PETs and LCTs) in the seven years before death, deducting exemptions and reliefs.
2. Apply the nil-rate band to the earliest transfers first.
3. Apply any transferable NRB and the residence nil-rate band if available (including downsizing and tapering).
4. Calculate IHT at 40% on the value above the available bands; apply 36% if the charity baseline test is satisfied.
5. Apply taper relief to gifts made more than three years before death (tax on those gifts only).
6. Recalculate LCTs at death rates and deduct any lifetime IHT already paid.
7. Apportion the IHT across assets (estate rate) and identify instalment options.
8. Apply exemptions and reliefs to the estate and earlier gifts; confirm liability and burden.

Worked Example 1.7

Graham dies leaving a house valued at £210,000 to Henry “subject to IHT”, and residue of £190,000 to Ian. He made no lifetime transfers. No RNRB applies. Calculate the estate rate and apportion tax.

Question: How is tax apportioned?

Answer:
NRB £325,000 covers the entire estate (£400,000), but assume hypothetically that £75,000 is chargeable at 40% because of prior gifts (to illustrate estate rate). Total IHT is £30,000 on a £400,000 chargeable estate. The estate rate is £30,000/£400,000 = 7.5%. Tax on the house is £210,000 × 7.5% = £15,750, and tax on residue is £190,000 × 7.5% = £14,250. Where the house is instalment option property, these apportioned amounts determine how much may be paid in instalments.

Applying Exemptions and Reliefs

Always deduct available exemptions (e.g., spouse exemption, annual exemption, normal expenditure out of income) and reliefs (e.g., business or agricultural relief) before calculating the IHT liability. Exemptions and reliefs can apply to both lifetime transfers and the estate on death. For spouse exemption, check domicile status and consider the non-dom spouse election for unlimited exemption. For RNRB, verify “closely inherited” descendants and the £2 million taper threshold. For business and agricultural relief, confirm qualifying assets and percentages.

Where appropriate, consider section 144 IHTA (discretionary will trusts distributed within two years): distributions may be “written back” to the will for IHT purposes, avoiding exit charges and potentially achieving more favourable outcomes without charging trust anniversary/exit rates within that period.

Exam Warning

For SQE1, always check the dates and values of all gifts made in the seven years before death. Failing to account for earlier gifts can lead to incorrect IHT calculations. Do not apply taper relief to the estate; it applies only to tax on gifts. If an LCT is within seven years of death, recalculate at 40% and give credit for lifetime tax; do not refund if recalculated tax after taper is lower.

Revision Tip

When answering IHT calculation questions, write out the steps in order and show all workings. This helps avoid errors and ensures you apply the correct bands and reliefs. Explicitly label NRB usage, RNRB checks, charity baseline tests, taper relief on gifts, and credits for lifetime tax. Where instalment options or estate rate apportionment are relevant, state the basis clearly.

Key Point Checklist

This article has covered the following key knowledge points:

• The distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs)
• The effect of the nil-rate band and residence nil-rate band on IHT calculations, including transferable bands and tapering above £2 million
• The main exemptions and reliefs available for IHT, including spouse exemption (domicile rules), annual exemption, small gifts, normal expenditure out of income, business relief, agricultural relief
• The correct order for calculating IHT on death, including the impact of previous gifts and separate cumulation periods for failed PETs
• The operation of taper relief (reducing tax on gifts only) and gifts with reservation of benefit
• The reduced charity rate at 36% when the 10% baseline test is met
• Liability vs burden of tax; PRs’, trustees’ and donees’ responsibilities and time limits
• The apportionment of tax by estate rate and use of the instalment option for qualifying assets
• Credit for lifetime tax already paid on LCTs and the grossing up mechanism when the donor pays lifetime IHT
• Quick succession relief where assets are taxed twice within five years

Key Terms and Concepts

• potentially exempt transfer (PET)
• lifetime chargeable transfer (LCT)
• nil-rate band (NRB)
• residence nil-rate band (RNRB)
• spouse exemption
• annual exemption
• normal expenditure out of income
• business relief
• agricultural relief
• taper relief
• gift with reservation of benefit
• grossing up (lifetime LCT)
• instalment option
• estate rate
• quick succession relief (QSR)