This article first appeared in the Staffordshire Newsletter as a guest column written by Matt Bailey Managing Director.
More families are liable to pay Inheritance Tax (IHT) thanks to rising house prices, so it is no surprise that they are looking to lifetime giving as a legitimate way of passing on their wealth to future generations.
Once all the allowances have been taken into consideration, any gift is a Potentially Exempt Transfer (PET). Taper relief plays an important role by reducing the charge payable but, get it wrong, and your beneficiaries could face a shock tax bill.
PETs fall outside of your estate for Inheritance Tax purposes if you survive for seven years, otherwise tax is charged on a sliding scale basis known as taper relief. For a death within the first three years, IHT is charged at 40%. The tax payable then reduces by 20% on each anniversary after the third year.
However, the way IHT legislation applies means that taper relief may not be as valuable in offsetting tax as you might expect. Die within seven years and a PET fails. Failed PETs are taxed first, in chronological order, and problems can arise if the PET is covered by the Nil Rate Band since taper relief may apply but will not reduce the tax charge.
Let’s look at the case of Bill and wife Mary, whose estate is worth £1million including cash deposit accounts totalling £200,000. Untouched for years, the accounts are in Bill’s sole name and don’t affect his or Mary’s disposable income. Bill decides to gift their son £100,000. Since Bill expects to live at least another seven years he believes – incorrectly – that for every year he survives past the ‘three-year marker’, taper relief on the potential IHT due on their joint estate will reduce by £8,000 per annum, minimising any tax liability on his death. Bill dies after one year and under PET legislation the £100,000 gift is taxed at 40%, resulting in a £40,000 tax bill.
So, where did Bill go wrong? If surplus cash had been gifted many years earlier, Bill would more likely have survived the seven-year rule governing PET legislation. The second error was to hold the cash in his name only rather than in joint accounts with his wife. Since Mary survived him, a gift from a joint account could have saved at least 50% of the tax. For PET purposes, HMRC may have treated the gift as being an equal gift of £50,000 from Bill and £50,000 from his wife. Therefore, as Mary is still living, it could be argued that no IHT would have been payable on her 50% of the gift, thereby saving £20,000 in Inheritance Tax.
If Bill and Mary had each elected to use their £3,000 annual allowances, the total taxable gift would have been reduced to £94,000, and unused reliefs from previous years could have recused the gift by a further £6,000. Depending on his health, Bill could have elected to use part of his chargeable lifetime allowance on such gifts, where the rate is 20% if the recipient pays the tax or 25% if the donor pays it.
Our example shows how complex Inheritance Tax can be. Other options could have mitigated the IHT liability, but would have required forward planning. Professional advice is therefore essential to ensure your wealth is passed on to beneficiaries in accordance with your wishes. Anyone with an estate of £650,000 or more can take advantage of a free wealth check with Howards Chartered Certified Accountants.