Inheritance Tax on lifetime transfers and transfers on death - Overview of Inheritance Tax (IHT)

Learning Outcomes

After reading this article, you will be able to explain the main rules and principles of Inheritance Tax (IHT) as they apply to both lifetime transfers and transfers on death. You will be able to identify and apply the concepts of potentially exempt transfers (PETs), nil rate bands, key exemptions and reliefs, and the IHT treatment of trusts. You will also be able to calculate IHT liabilities in common scenarios, and recognise the practical and technical issues that arise in SQE1-style questions.

SQE1 Syllabus

For SQE1, you are required to understand the application of Inheritance Tax to both lifetime transfers and transfers on death. In your revision, focus on:

• the distinction between potentially exempt transfers (PETs) and chargeable lifetime transfers (CLTs)
• the operation of the nil rate band and residence nil rate band (RNRB)
• the effect of lifetime gifts on the available nil rate band at death
• the main IHT exemptions and reliefs (including spouse exemption, annual exemption, small gifts, gifts out of income, business and agricultural relief)
• the IHT treatment of trusts, including entry, periodic, and exit charges
• calculation of IHT liabilities in typical exam scenarios

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 a potentially exempt transfer (PET), and when does it become chargeable to IHT?
2. How does the nil rate band operate in relation to lifetime gifts and transfers on death?
3. Name three main exemptions from IHT that can apply to lifetime gifts.
4. What is the maximum IHT rate on a discretionary trust’s ten-year anniversary charge?
5. How does the residence nil rate band (RNRB) increase the IHT threshold, and when does it apply?

Introduction

Inheritance Tax (IHT) is a tax on the transfer of wealth, charged on certain gifts made during a person’s lifetime and on the value of their estate at death. For SQE1, you must be able to distinguish between the different types of transfers, apply the correct exemptions and reliefs, and calculate the IHT liability in common scenarios. This article provides an overview of the key rules and concepts.

Lifetime Transfers: PETs and CLTs

IHT can arise on transfers made during a person’s lifetime. There are two main categories:

• Potentially Exempt Transfers (PETs): Gifts made by an individual to another individual (or to certain trusts for disabled persons or bereaved minors). PETs are not immediately chargeable to IHT, but become chargeable if the donor dies within seven years of the gift.
• Chargeable Lifetime Transfers (CLTs): Gifts made to most types of trusts (e.g., discretionary trusts) or companies. CLTs are immediately chargeable to IHT if they exceed the available nil rate band.

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

Key Term: chargeable lifetime transfer (CLT) A gift made during lifetime (usually to a trust or company) that is immediately chargeable to IHT if it exceeds the nil rate band.

The Seven-Year Rule and Taper Relief

If the donor survives seven years after making a PET, the gift is exempt from IHT. If the donor dies within seven years, the PET becomes chargeable and uses up part of the nil rate band. If death occurs more than three years after the gift, taper relief reduces the tax payable on the PET.

Key Term: taper relief A reduction in the IHT payable on a PET or CLT if the donor dies more than three years but less than seven years after the gift.

Worked Example 1.1

Aisha gives £250,000 to her son in April 2016. She makes no other gifts. She dies in May 2022. What is the IHT position?

Answer: The gift is a PET. Aisha died just over six years after the gift, so the PET becomes chargeable. The gift uses up £250,000 of the nil rate band available at death. Taper relief applies (since death was more than five but less than six years after the gift), so only 40% of the full IHT rate is payable on any part of the PET above the nil rate band.

Transfers on Death and Nil Rate Bands

On death, IHT is charged on the value of the deceased’s estate, including assets in their sole name and certain trust interests. The nil rate band (NRB) is the threshold below which no IHT is payable.

Key Term: nil rate band (NRB) The amount of an estate (or chargeable transfers) that is taxed at 0% for IHT purposes. The standard NRB is £325,000.

The Residence Nil Rate Band (RNRB)

If a person leaves a qualifying residence to direct descendants, an additional residence nil rate band (RNRB) may apply, increasing the IHT-free threshold.

Key Term: residence nil rate band (RNRB) An additional IHT-free allowance (up to £175,000) when a home is left to direct descendants, subject to tapering for estates over £2 million.

Worked Example 1.2

John dies in 2023/24, leaving an estate of £600,000, including his house worth £300,000, to his children. He made no lifetime gifts. What is the IHT liability?

Answer: The estate benefits from the standard NRB (£325,000) and the full RNRB (£175,000), giving a total threshold of £500,000. The taxable estate is £600,000 – £500,000 = £100,000. IHT at 40% is £40,000.

Exemptions and Reliefs

Certain gifts and transfers are exempt from IHT, either in whole or in part.

Key Term: spouse exemption Transfers between spouses or civil partners are exempt from IHT, regardless of amount or timing.

Key Term: annual exemption Each individual can give away up to £3,000 per tax year free of IHT. Unused exemption can be carried forward one year.

Key Term: small gifts exemption Gifts of up to £250 per recipient per tax year are exempt, provided the recipient does not also receive part of the annual exemption.

Key Term: gifts out of income Regular gifts made out of surplus income, which do not affect the donor’s standard of living, are exempt from IHT.

Other important exemptions include gifts in consideration of marriage (up to specified limits), gifts to charities, and gifts for family maintenance.

Worked Example 1.3

Fatima gives £2,000 to each of her four grandchildren in one tax year. How much of these gifts is exempt from IHT?

Answer: The first £3,000 is covered by the annual exemption. The remaining £5,000 (£8,000 – £3,000) is covered by the small gifts exemption (£250 per recipient × 4 = £1,000). The balance (£4,000) is a PET.

Reliefs: Business and Agricultural Property

Certain business and agricultural assets attract relief from IHT, reducing or eliminating the tax payable.

Key Term: business relief A relief reducing the value of relevant business property for IHT purposes by 50% or 100%, provided qualifying conditions are met.

Key Term: agricultural relief A relief reducing the value of qualifying agricultural property for IHT purposes by 50% or 100%, subject to conditions.

The Cumulative Principle and Lifetime Gifts

When calculating IHT on death, all chargeable transfers made in the seven years before death are cumulated with the death estate. PETs that become chargeable and CLTs are deducted from the nil rate band first, reducing the threshold available for the death estate.

Worked Example 1.4

Omar made a CLT of £200,000 to a discretionary trust in 2018. He dies in 2024, leaving an estate of £400,000. What is the available nil rate band for his estate?

Answer: The CLT uses up £200,000 of the NRB. Only £125,000 of the NRB remains for the death estate. The taxable estate is £400,000 – £125,000 = £275,000.

IHT and Trusts

Trusts are subject to special IHT rules. The main types are:

• Bare trusts: The beneficiary is treated as owning the assets outright for IHT.
• Interest in possession trusts: The beneficiary with a right to income is treated as owning the trust assets for IHT.
• Discretionary trusts (relevant property trusts): The trust itself is subject to entry, periodic (ten-year), and exit charges.

Key Term: entry charge An immediate IHT charge (at 20%) on assets transferred into a discretionary trust above the nil rate band.

Key Term: periodic charge A charge (up to 6%) on the value of trust assets above the nil rate band every ten years.

Key Term: exit charge A proportionate charge on assets leaving a discretionary trust between ten-year anniversaries.

Worked Example 1.5

Priya settles £500,000 into a discretionary trust in 2022. She has made no previous gifts. What is the IHT entry charge?

Answer: The first £325,000 is covered by the NRB. The excess (£175,000) is charged at 20%, so the entry charge is £35,000.

Calculation of IHT

The main steps in calculating IHT are:

1. Identify all chargeable transfers (lifetime and on death) in the seven years before death.
2. Apply available exemptions and reliefs.
3. Deduct chargeable transfers from the nil rate band.
4. Apply the RNRB if available.
5. Calculate IHT at 40% on the taxable estate (or 20% for CLTs).
6. Apply taper relief if appropriate.

Exam Warning

For SQE1, always check the order of gifts and the effect of earlier transfers on the nil rate band. Remember that PETs only become chargeable if the donor dies within seven years, and that CLTs are always chargeable when made.

Summary Table: Key IHT Thresholds and Rates

Key Point Checklist

This article has covered the following key knowledge points:

• The distinction between potentially exempt transfers (PETs) and chargeable lifetime transfers (CLTs) for IHT.
• The operation of the nil rate band (NRB) and residence nil rate band (RNRB) in reducing IHT.
• The main IHT exemptions and reliefs, including spouse exemption, annual exemption, small gifts, gifts out of income, business and agricultural relief.
• The IHT treatment of trusts, including entry, periodic, and exit charges.
• The calculation of IHT liabilities, including the effect of lifetime gifts and taper relief.

Key Terms and Concepts

• potentially exempt transfer (PET)
• chargeable lifetime transfer (CLT)
• taper relief
• nil rate band (NRB)
• residence nil rate band (RNRB)
• spouse exemption
• annual exemption
• small gifts exemption
• gifts out of income
• business relief
• agricultural relief
• entry charge
• periodic charge
• exit charge