Is inheritance tax due on a gift?

Is inheritance tax due on a gift? I have an elderly friend who has said he would like to give me a gift of £10,000 to help with my planned kitchen extension. Will there be any tax to pay on this very generous gift?

If you make a gift during your lifetime, there will not usually be any inheritance tax (IHT) to pay. Lifetime gifts are usually treated as potentially exempt transfers (PETs) and will only become chargeable to IHT if you die within seven years of making the gift.

However, if you make a gift to a company or to some types of trust, the gift is immediately chargeable and you may have to pay some tax in your lifetime – if the total value of those gifts exceeds the IHT threshold (currently £325,000).

Any money you give away during your lifetime that doesn’t fall under the exempt transfer rules may escape IHT as a potentially exempt transfer (PET). There are no limits on the amount of PETs you can make during your lifetime. Basically, for a PET to escape IHT completely you need to make sure that you survive for seven years after making the gift.

If you die within the seven year period, the PET will be partially chargeable depending on the number of years that have elapsed. The reduction is given in the form of taper relief. This is a sliding scale used to determine tax liabilities on gifts between three and seven years before death. The rates of taper relief are as follows:

  • Between 0 to 3 years, the reduction is 0% and the actual tax rate is 40%
  • 3 to 4 years, the reduction is 20% and the actual tax rate is 32%
  • 4 to 5 years, the reduction is 40% and the actual tax rate is 24%
  • 5 to 6 years, the reduction is 60% and the actual tax rate is 16%
  • 6 to 7 years, the reduction is 80% and the actual tax rate is 8%
  • More than 7 years, the reduction is 0% and the actual tax rate is 0%

Taper relief is only of real benefit if you can also fully use the nil rate band for other transfers. Taper amounts are set against the free slice first.

If you give £100,000 away during your lifetime and die four years later, leaving a further £350,000 in your will, the first £100,000 lifetime gift counts against your nil rate band first. So your estate will only have £225,000 (in 2015/16) left in nil rate band to set off against the remaining £350,000. This means that your executors will end up paying as much tax as if you had not made the gift at all.

Taper relief is worthwhile for those with large estates. Giving away £1 million and living for seven years takes the money right out of the IHT net. But if you only live for six years, the £1 million less the nil rate band is charged at only 8% tax instead of 40%. Obviously, anything that is transferred at death will be chargeable at the full 40% rate as the nil rate band will have been used up.

Many people use special life insurance policies to make sure that a potential liability to IHT is covered if they don’t live for the full seven years after making a PET. These types of policy are designed to fit in with the tax taper. The proceeds are usually written into trust so they are outside your estate when you die.

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