Inheritance tax exemptions
Written by Ray Coman
Inheritance tax is charged on the estate of a person when they die, and on certain gifts made during their life. The briefing below outlines the way that inheritance tax can arise on death, during life and the exemptions which are available to reduce this form of taxation.
Inheritance tax on death
When a person dies, the value of possessions at death will be included in the estate chargeable to inheritance tax. The chargeable estate will include any interests in trusts from which the deceased had a right to receive income. There is a separate guide on trusts which explains inheritance tax on trusts further.
Inheritance tax is payable on any estate with a value over the 'nil rate band' (of £325,000 for 2013/14.) The rate of inheritance tax is 40 per cent. In a simple example, if the estate was valued at £500,000, an amount of £175,000 would be subject to tax, and inheritance tax payable would be £70,000.
Lifetime inheritance tax
Unfortunately, it is not always possible to avoid inheritance tax by making lifetime gifts. The chargeable estate also includes gifts made in the seven years prior to death. This is because the nil rate band is reduced by lifetime transfers in the seven years before death. Inheritance tax on gifts made between three and seven years prior to death are reduced at a rate of 20% each year. Consequently, the effective rate of inheritance tax on a gift made between three and four years prior to death is 32%, the following year is 24%, the following year 16%, and between year six and seven is 8%.
A lifetime gift is called a 'potentially exempt transfer' (or PET), as it has the potential to be exempt once the donor has survived seven years.
Certain transfers to and from trusts are charged to 'lifetime inheritance tax' at 20% over the value of any available nil rate band. These gifts are not potentially exempt, but immediately chargeable. A trust arrangement is an area in which professional advice is recommended.
In addition to the lower rates that apply to lifetime gifts made between three and seven years prior to death there are a number of specific exemptions, including:
- Gifts for family maintenance and transfers of property on divorce under a court order.
- Gifts out of income, which form part of a regular pattern of giving. The gifts should come out of income, such as pension or wages, and not out of capital, and will only be exempt if they do not reduce the normal living standard of the donor. Examples would include life insurance premiums paid for the benefit of someone else, or regular payments to a family member.
- Small gifts of up to £250 per year, per recipient, for instance on Christmas presents. The exemption will not cover part of a gift of over £250.
- Gifts below the annual exemption of £3,000. Any annual exemption not used in the previous year can be carried forward one year so that up to £6,000 can be given away without causing an inheritance tax charge.
- Wedding presents for the bride and groom, up to £5,000 is available for a parent, £2,500 for a grandparent and £1,000 for anyone else.
A number of factors are likely to affect lifetime gifts. The donor should consider the impact of any significant property transfers on future financial security. Lifetime transfers, whilst avoiding inheritance tax, may give rise to an immediate capital gains tax liability.
Lifetime and death exemptions
Certain transfers will be exempt from inheritance tax whether made as a lifetime gift or under the direction of a Will.
Gifts between spouses are free from inheritance tax. The spousal exemption is valuable particularly in providing lifetime security to the surviving spouse and protecting the marital home. However, the transfer of an entire estate to a spouse would not make immediate use of nil rate band and other exemptions available for gifts made to others.
Inheritance tax is not due on a business interest as 100% business property relief will apply. Consequently, unquoted shares, which include those listed on the AIM stock exchange, can be free from inheritance tax. The value of assets owned by the donor and used in a partnership in which the donor is a partner will be reduced by business property relief of 50%. Further guidance is available on business property relief.
Agricultural property will attract agricultural property relief of 100%, providing certain conditions are met. The timber held in any woodland will be exempt from tax.
Business property relief applies to lifetime transfers and to transfers on death. As a result, the tax incentive to the transfer of business property during a lifetime is the same as a transfer made on death. However, the drawbacks of making a lifetime gift of a business asset, compared with a gift on death is that capital gains tax may apply during your lifetime. This is discussed further in the briefing on tax consequences of investing in a family business.
Moreover, as with all other gifts made in the seven years prior to death, business assets will be brought back into your estate. If the assets no longer qualifies for business assets property relief, for instance because the donee has sold the asset, then there will not be any tax relief.
Gifts to charities, national institutions and certain political parties made either during lifetime or death. Further information is available here for tax incentives on transfers to a public institution.
Where over 10% of an estate is donated to charity, the remainder of the estate, over the nil rate band will be subject to tax at 36% rather than 40%.
Whilst the above provides a general overview of the subject, individual circumstances must be taken into account and the interaction of inheritance tax with other tax should be considered. We would be pleased to help tailor a plan to minimise your inheritance tax. Please contact us to discuss if you would like advice in this area.