By Michael Steed Accountancy resources A guide to inheritance tax – part 1 14 Nov 2013 Inheritance Tax – a tax levied in the UK on property and money acquired by gift or inheritance – is a highly emotive subject. In part one of a two-part series, tax expert Michael Steed MAAT outlines how the tax works and how you can legally manage your finances to avoid paying it Inheritance Tax (IHT) planning is generally about trying to get a balance between keeping enough to have a comfortable lifestyle in retirement and passing on wealth to family and occasionally friends, which helps us avoid paying it. The way I explain IHT to people is to tell them that it affects them both in life and in death. This often comes as a surprise. Most people understand the concept of the Taxman coming after their estate at death, but few understand that he could come after them while they are still alive. Inheritance Tax on a death estate Exposure at death is easy to understand. A person will incur IHT at 40% on a death estate, to the extent that the estate is over the nil-rate band (NRB), which is currently £325,000. But that’s only the simple view. That £325,000 has got to do lots of work. It must cover not just the death estate, but also all the gifts made in the previous seven years. That’s chargeable gifts, so not gifts to a spouse or to charity: they are ignored as ‘exempt transfers’. So if you gave away £200,000 in cash to your children and died two years later with an estate worth £300,000, the £325,000 NRB would have to cover the £200,000 gift first. What’s left of the NRB (£125,000) would be available for set-off against the death estate. So there would be an IHT liability of 40% of £175,000; in other words, £70,000 goes straight to HMRC. The three types of gifts that can beat Inheritance Tax There are three sorts of lifetime gift: exempt gifts, potentially exempt gifts and gifts that are chargeable when they are made. An exempt gift is a gift to a spouse (or civil partner) or charity. Gifts to political parties also qualify. These are also exempt in death, but I’m only considering lifetime gifts here. Potentially exempt gifts and the seven-year rule A potentially exempt gift (called a potentially exempt transfer, or PET) is a gift by one individual to another individual. So a father giving to a son and a mother giving to a daughter would both qualify as PETs. The important thing about a PET is that it is only potentially exempt. It is fully exempt only if the donor survives seven years after giving the gift. If the donor does not survive for seven years, bad things start to happen: the gift becomes chargeable to the extent that it is above the NRB, and the person who has to pay the IHT is the recipient of the gift. This can be mitigated by taper relief if the donor survives at least three of the seven years. By the way, a PET can be any property, including cash, shares, land and buildings. It is not capped; the gift can be for any amount – there’s still no tax to pay in life. Chargeable gifts incur IHT when they are made. This includes most gifts not covered by the other two categories, such as transfers to companies or certain kinds of trust. How the seven-year window rule works The accumulator is the other critical piece of information that you need if you are to understand the IHT angles of lifetime giving. This is a seven-year window that moves with the lifespan of a donor of gifts. It never changes in length; it is always seven years. The movement of the accumulator means a lifetime gift will be counted for seven years and then fall out of the accumulator. From that point on it is ignored by the IHT system. This is why professional advice always says to give property away as soon as you can, to allow the greatest chance of surviving the magic seven years. A PET does not enter the accumulator in life. It is ignored. So – and this is crucial – it does not use up any of the NRB. But the situation is very different if the donor dies; then the accumulator locks down and all chargeable gifts in the seven years before death are counted and will soak up the NRB. The only gifts that do enter the accumulator in life are gifts into trusts: discretionary trusts (known in IHT-speak as relevant property trusts, or rpts). These are chargeable to IHT, but only to the extent that the gift is above the available NRB. So a gift under the available NRB is effectively free from IHT and a gift above the available NRB will be charged at 20% (ie, half the death rate of IHT). This is part one of a two-part post on Inheritance Tax. Michael’s second post looks at what happens at death from an IHT point of view. Michael Steed is co-chairman of the ATT's tax Technical Steering Group and columnist for Accounting Technician magazine.