Most people understand that if you make a reasonable size gift, you need to survive seven years before it falls out of your estate for inheritance tax purposes.
So why do the HMRC probate forms ask about gifts made in the seven years prior to death and the seven years prior to that also? A period in total of 14 years.
The answer is that you can accidentally have gifts made up to 14 years ago, falling back into the calculation of Inheritance Tax (IHT) when you die.
There are three types of gifts in the UK: Exempt Transfers (ETs), Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs). ETs are not relevant for the 14-year rule and so we will ignore them.
Broadly a PET is a gift to an individual and a CLT is a gift to a Discretionary Trust. These two types of gifts can interact with each other negatively and so it is important to plan them out. Simply put, if you die within seven years of making a CLT, you look back seven years from the CLT and if there is a PET within that period it will be brought back in and uses up the Nil Rate Band on the CLT. This can increase the IHT payable,
So, if you were to make a £325,000 CLT in 2020, a £325,000 PET in 2026 and die in 2032, despite having survived more than seven years after the original CLT you will still have increased inheritance tax. The PET was within seven years and so will use up your entire nil rate band of £325,000, meaning in effect that the estate pays 40% inheritance tax on £325,000 more of your estate (£130,000 tax) than if you had survived until 2033. So far, so normal. However, as the CLT was within seven years of the PET, this amount is also brought back into account (although fortunately not taxable at the full 40% inheritance tax).
That CLT whilst outside of the seven years for inheritance tax on the estate, now creates a problem for whoever you gave the £325,000 to in 2026. Suddenly, they now owe some inheritance tax themselves. Essentially the CLT uses up the whole of the £325,000 nil rate band for the PET beneficiary. So, they now owe 40% inheritance tax on the gift they received 6 years ago. Their only saving grace is that they can claim the full amount of taper relief and so the tax due is only 20% (this amount of taper relief because you made it to six years) of that amount of £130,000 and so they owe just £26,000.
It is likely that the person you kindly gave the £325,000 to 6 years ago, knows nothing about the trust you set-up 12 years ago and so this tax bill might come as a bit of a surprise. This is why with inheritance tax planning and gifts, it is crucial to keep good records of the gifts you have made to trusts and individuals, otherwise you leave a mess for your executors to sort out.
We are currently maintaining extensive gift registers for our clients (the oldest going back to 2001) from our Head Office in Hook, Hampshire, across the South in person and nationwide using the latest technology. If your adviser can’t produce the same, get in touch.