One of the simplest ways to mitigate inheritance tax ('IHT') exposure is to make gifts during your lifetime. This can reduce the assets in your estate and therefore the IHT bill on your death. However, this benefit does not happen immediately when the gift is made.
What is the 7-year rule?
The starting point is the so called "7-year rule" which says that the person making the gift must survive for 7 years from the date of the gift, for the value of the gift to fall out of their estate for IHT purposes.
There are some gifts, such as gifts to your spouse, to charity or gifts within your annual exemption of £3,000, which are immediately exempt from IHT. If the person dies between 3 and 7 years after making the gift, taper relief can help reduce the IHT liability.
The Office of Tax Simplification has recommended that the 7 year period be reduced to 5 years and that taper relief be abolished. For now, those changes have not been implemented and the 7-year rule remains in place.
So, what is the 14-year rule all about?
Without careful planning, the 7-year rule can become the 14-year rule. This happens when a person has made a gift to a trust (a 'chargeable lifetime transfer' or 'CLT') and, less than 7 years later, makes a gift to an individual (a 'potentially exempt transfer' of 'PET').
If that person dies within 7 years of having made the PET, then both the original gift to trust and the subsequent gift to the individual are added back on to the total estate for IHT purposes.
This happens because the IHT nil rate band (£325,000) is set against the gifts in chronological order. Until the first 7-year period (immediately after the original CLT) has expired, the gifter's IHT nil rate band has not 'refreshed' and is therefore not available to be set against the second gift, the failed PET.
An illustrative example
In extreme cases, this could effectively extend the 7-year window to 14 years. This can be demonstrated by an example:
- Phil puts £300,000 into trust for the benefit of Dennis, Toni and Steve;
- 6 years and 364 days later, Phil gifts £100,000 to each of Michael and Scottie; and
- 6 years and 364 days after that, Phil dies.
On Phil's death, the gifts to Michael and Scottie are failed PETs, because Phil did not survive for 7 years after making them. To assess the IHT payable on those failed PETs following Phil's death, we must look back 7 years from the date of the PETs. In this example, a gift made (practically) 14 years before Phil's death is relevant for calculating the IHT bill on his death.
Here, there was a CLT (the gift to trust) less than 7 years before the failed PET. This used up £300,000 of the £325,000 nil rate band. A period of 7 years had not passed after the CLT, so the available nil rate band was just £25,000 at the time when the PETs to Michael and Scottie were made. The total of £200,000 of failed PETs are therefore only reduced by £25,000, meaning that there are £175,000 worth of chargeable gifts in account.
In this example, had Phil waited until 7 years had passed from the gift to the trust, then the whole £325,000 nil rate band would have been available to use against the PETs. That would cover the PETs in full and leave a further £125,000 to be set against other assets in Phil's estate, reducing his other assets by that amount and saving a further £50,000 of IHT.
This highlights the important of taking advice before embarking on what may seem like simple estate planning. If you or your clients are considering estate planning, and want to discuss the IHT consequences of gifting, please get in touch.
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Senior Associate
