This article is inspired out of a need to correct one of the most common misconceptions many people have about gifts. We hear all too often people, having made a gift or considering one, state that they believe the gift will pass out of their estates after 7 years and that taper relief will apply in the meantime.
It is possible neither may be true, as it depends so much on circumstances. However, gifting an asset (money, property etc.) to beneficiaries will often have neither of the above benefits applied to them. The rules in these areas are far from straightforward and in some ways are quite complex.
For the sake of brevity, we try to take quite a simple view and line to explain more about the misconceptions. The fact that these misconceptions apply so widely, simply accentuates the need for anyone looking to reduce their liability to Inheritance Tax to take proper, specialised advice.
Firstly, not all gifts are exempt and not all are Potentially Exempt Transfers.
Gifts can be categorized either as Chargeable Lifetime Transfers (CLTs) or Potentially Exempt Transfers (PETs). It is important to ascertain what type of gift you are making or wish to make. It can often be preferable to make the gift as a CLT, subject to individual circumstances.
In addition, gifts that are exempt should be maximised first and foremost as these will normally be completely outside of any IHT calculation, so the use of the annual exemption, one off exemptions (e.g. gifts on marriage) and the gift out of normal income exemption should always be used in front of a PET or CLT.
Secondly, if a gift is made and it is deemed to be a PET then the way this is dealt with does not correspond to how many think it is.
It is accurate to state that the value of a PET will fall completely outside of the estate, for IHT purposes, if the person who made the gift (the donor) survives for seven years after the date of the gift.
Most people are familiar with this seven-year period but have you heard of the fourteen-year rule that applies to gifts, if you do not survive the seven years? This rule is to discourage serial gifting as a means of reducing your estate.
Let’s use an example; if you gifted £100,000 in July 2007 and £100,000 again in June 2014 and died before June 2021, the values of both gifts will be entered back in your estate and become subject to IHT. Why? With the fourteen-year rule in place, you have effectively reset the seven year clock on the first gift as the initial seven year period was not complete. You can of course continue to gift up to your annual allowances but we would rarely recommend gifting above your allowances more than once in seven years as this effectively changes the timespan to fourteen years!
If an individual dies within seven years after making a PET then the value of that PET would be aggregated with the deceased’s free estate to determine what, if any, IHT is due. The PET will therefore use up some or all of the available nil‑rate band (NRB), potentially exacerbating or even creating an IHT liability for the estate.
Also, if the value of the PET exceeds the NRB, current at the date of death, then additional IHT will be payable by the recipient of the gift. Taper relief may reduce the amount of tax payable.
Many people make the mistake of thinking that the taper reduces the value of the gift, it does NOT. Do also consider that Taper Relief does not apply to any gift below the Nil Rate Band (£325,000), so a £100,000 gift will be chargeable at 40% at any time in the seven-year period.
So a gift of £350,000 does not taper in years 3-7 – taper relief applies to the amount of the gift that may be taxable at the point of death. This may sound the same, but it is actually quite different and can produce a very different (and worse) tax position.
PETs can be an extremely valuable tool in IHT planning and can often be used as a method of reducing an eventual IHT liability but it is important that some of the complexities of how gifts are calculated and dealt with are properly factored in, because some of the misconceptions can easily lead to financial planning mistakes.
Do also consider the negatives of Gifting; loss of control of the asset, financial independence given away and ownership passing to third parties in divorce, creditor or bankruptcy scenario’s. Once you have given it away, you can’t take it back!
There are arguably quicker and less complicated ways of removing assets from your estate than gifting and waiting seven years, ways which still give you ownership and control.