After years of hard work accumulating and growing wealth, many individuals fail to properly consider the steps required to structure their estate for efficient distribution of wealth.
A good estate plan ensures that both during life and on death, wealth can pass to individuals based on the needs and intentions of the donor.
However, it seems that over time the family structure has become more complex. Divorce and remarriage, children and step-children of wide ranging ages, and marriages of mixed domicile only serve to add more complexity toan estate plan. It is therefore more likely that a number of different types of gifts need to be utilised in order to satisfy greater demands.
Understanding gifts
For the UK-domiciled individual, once multiple types of gifts are created, it is important to assess the inheritance tax (IHT) impact these gifts have on each other. Armed with knowledge of the types of gifts and how they are taxed, it is possible to structure the order of gifting to minimise any immediate or future liability to tax.
From a UK inheritance tax perspective, there are three main types of gifts made during life. Exempt gifts do not create any immediate or future IHT liability.
However Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs) can create liabilities to tax.
Handling PETs
On the creation of a PET there is no immediate liability to IHT and there is no maximum value that can be gifted.
However, the donor has to survive a full seven years from the date of the gift before the gift becomes exempt from IHT. If death occurs within seven years of the PET it will become chargeable, and tax will be payable at 40% on the excess over the donor’s available nil-rate band (taper relief can apply to reduce the inheritance tax due if death occurs between three and seven years of making the gift).
This is often referred to as a failed PET. In calculating the available nil-rate band, all transfers made in the seven-year period before the date of the transfer must be considered. This means that gifts made up to 14 years prior to death may impact on the available nil-rate band for a failed PET.
Chargeable transfers
A chargeable transfer will create an immediate liability to IHT if it, together with any other chargeable transfers made in the previous seven years, exceeds the donor’s available nil-rate band. The excess amount is taxed at 20% (if paid by the trustees), which is one half of the death rate of inheritance tax.
There is no further IHT to pay on the gift, as long as the settlor survives for seven years. If, however, the donor should die within seven years of making the gift, IHT is recalculated at the death rate to determine any additional liability.
For this calculation, the available nil-rate band is reduced by the value of any chargeable transfers made in the seven years preceding the gift. So again, it is possible that gifts made up to 14 years prior to death could impact on the available nil-rate band.
As chargeable transfers involve gifts into arrangements where there is flexibility on who can ultimately benefit, such as a discretionary trust, the value of the gift can in effect come out of IHT circulation indefinitely.
To offset this, chargeable transfers are subject to a periodic charge at each ten-year anniversary and on exit. In its simplest terms, the periodic charge assumes a chargeable transfer has been made, equivalent to the value of the trust fund at each ten-year anniversary.
In calculating the value of the assumed transfer liable to the periodic charge, the trust can avail of its own nil-rate band. However, this is reduced by any chargeable transfers made in the seven years before the trust was created, which is the important aspect when considering the order of gifts, and by any withdrawals made from the trust in the preceding ten-year period.
An “effective rate” of tax is applied to the assumed transfer, which is 30% of the lifetime rate of 20%; a maximum charge of 6%.
The exit charge is calculated in a similar way, but is a proportion of the ten-year charge based on the number of complete three-month periods that have elapsed since outset, or the last ten-year periodic charge.
Impact on gift order
There are two key points to pick out that will impact on the order of gifting. First, chargeable transfers made up to seven years prior to another chargeable transfer will reduce the available nil-rate band of the later transfer, and have a direct impact on the ten-year periodic charge and exit charge calculation.
Second, a failed PET is treated as a chargeable transfer. This means that if a PET is made before a CLT and it subsequently fails, it will be brought into account for the purposes of the ten-year charge on the CLT.
Exit charges
However, if a PET is made after a CLT, and subsequently fails, then it will not have the effect of reducing the nil-rate band for the purposes of the ten-year charge or exit charge calculation.
It is also worth noting that a loan made to a discretionary loan trust will not be considered as a CLT, as there is no loss to the estate. However, future ten-year periodic and exit charges may apply, if the value of the trust exceeds the outstanding loan.
As can be seen, careful consideration should be given to the order of gifting. Personal circumstances may dictate how and when gifts are made. However, to prevent any unnecessary tax charges, it is usually best to gift in the order shown in the box below. The impact of creating gifts in an order other than that shown, can have a dramatic impact on the ten-year periodic charge and exit charge of a CLT.
Therefore, if there are no personal reasons for creating gifts in a certain order, and an estate plan is being put in place to help reduce liability to IHT, it is important for the UK-domiciled individual to plan the order in which they gift.
| 1: Discretionary Loan Trust As the initial contribution is a loan and not a gift, the discretionary loan trust does not create a CLT or PET, and therefore does not reduce the available nil-rate band for subsequent gifts. However, the nil-rate band of the discretionary loan trust will be directly impacted by CLTs (including failed PETs) made up to seven years prior. A discretionary loan trust should therefore be created first. |
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2: Chargeable Lifetime Transfers
A CLT should be made after a discretionary loan trust but before any PETs. If possible it is also advisable to keep a full seven years between making a CLT and any other chargeable transfers. |
| 3: Potentially Exempt Transfers If death occurs within seven years of a PET, the PET will become chargeable and it will directly impact on other CLTs made in the seven years after the date of transfer. Therefore, provided that PETs are made after any CLTs, even if they do fail, they will have no impact on the available nil-rate band of any previous chargeable transfers. |
