PETs are lifetime gifts made directly to other individuals, which includes gifts to bare trusts. A similar lifetime gift made to most other types of trust is a CLT. These rules apply to non-exempt transfers: gifts to a spouse are exempt, so are not subject to IHT.
Survival for at least seven years ensures full exemption from IHT
Where a PET fails to satisfy the conditions to remain exempt – because the person who made the gift died within seven years – its value will form part of their estate. Survival for at least seven years, on the other hand, ensures full exemption from IHT. A CLT is not conditionally exempt from IHT. If it is covered by the nil-rate band and the transferor survives at least seven years, it will not attract a tax liability, but it could still impact on other chargeable transfers.
A CLT that exceeds the available nil-rate band when it is made results in a lifetime IHT liability. Failure to survive for seven years results in the value of the CLT being included in the estate. If the CLT is subject to further IHT on death, a credit is given for any lifetime IHT paid.
Transferred amounts less any IHT exemptions is ‘notionally’ returned to the estate
Following a gift to an individual or a bare trust (a basic trust in which the beneficiary has the absolute right to the capital and assets within the trust, as well as the income generated from these assets), there are two potential outcomes: survival for seven years or more, and death before then. The former results in the PET becoming fully exempt, and it no longer figures in the IHT assessment. In other cases, the amount transferred less any IHT exemptions is ‘notionally’ returned to the estate.
Anyone utilising PETs for tax mitigation purposes, therefore, should consider the consequences of failing to survive for seven years. Such an assessment will involve balancing the likelihood of surviving for seven years against the tax consequences of death within that period.
Determining whether taper relief can reduce the tax bill for the recipient of the PET
Failure to survive for the required seven-year period results in the full value of the PET transfer being notionally included within the estate; survival beyond then means nothing is included. It is taper relief which reduces the IHT liability (not the value transferred) on the failed PET after its full value has been returned to the estate. The value of the PET itself is never tapered. The recipient of the failed PET is liable for the IHT due on the gift itself and benefits from any taper relief. The IHT due on the PET is deducted from the total IHT bill, and the estate is liable for the balance.
Lifetime transfers are dealt with in chronological order upon death; earlier transfers are dealt with in priority to later ones, all of which are considered before the death estate. If a lifetime transfer is subject to IHT because the nil-rate band is not sufficient to cover it, the next step is to determine whether taper relief can reduce the tax bill for the recipient of the PET.
Sliding scale dependant on the passage of time from giving the gift to death
The amount of IHT payable is not static over the seven years prior to death. Rather, it is reduced according to a sliding scale dependant on the passage of time from the giving of the gift to the individual’s death.
No relief is available if death is within three years of the lifetime transfer. Survival for between three and seven years and taper relief at the following rates is available.
Tax treatment of CLTs has some similarities to PETs
The tax treatment of CLTs has some similarities to PETs but with a number of differences. When a CLT is made, it is assessed against the donor’s nil-rate band. If there is an excess above the nil-rate band, it is taxed at 20% if the recipient pays the tax or 25% if the donor pays the tax.
The same seven-year rule that applies to PETs then applies. Failure to survive to the end of this period results in IHT becoming due on the CLT, payable by the recipient. The tax rate is the usual 40% on amounts in excess of the nil-rate band, but taper relief can reduce the tax bill, and credit is given for any lifetime tax paid.
Potentially increasing the IHT bill for those that fail to survive for long enough
The seven-year rules that apply to PETs and CLTs potentially increase the IHT bill for those that fail to survive for long enough after making a gift of capital. If IHT is due in respect of the failed PET in and of itself, it’s payable by the recipient. If IHT is due in respect of a CLT on death, its payable by the trustees. Any remaining IHT is payable by the estate.
The potential IHT difference can be calculated and covered by a level or decreasing term assurance policy written in an appropriate trust for the benefit of whoever will be affected by the IHT liability and in order to keep the proceeds out of the settlor’s IHT estate. Which is more suitable and the level of cover required will depend on the circumstances.
Covering the gradually declining tax liability that may fall on the gift recipient
If the PET or CLT is within the nil-rate band, taper relief will not apply. However, this does not mean that no cover is required. Death within seven years will result in the full value of the transfer being included in the estate, with the knock-on effect that other estate assets up to the value of the PET or CLT could suffer tax that they would have avoided had the donor survived for seven years. A seven-year level term policy could be the most appropriate type of policy in this situation. Any additional IHT is payable by the estate, so a trust for the benefit of the estate legatees will normally be required.
Where the PET or CLT will exceed the nil-rate band, the tapered IHT liability that will result from death after the PET or CLT was made can be estimated, and a special form of ‘gift inter vivos’ (a life assurance policy that provides a lump sum to cover the potential IHT liability that could arise if the donor of a gift dies within seven years of making the gift ) is put in place (written in an appropriate trust) to cover the gradually declining tax liability that may fall on the recipient of the gift.
Level term policy written in an appropriate trust for estate legatees might be required
Trustees might want to use a life of another policy to cover a potential liability. Taper relief only applies to the tax: the full value of the gift is included within the estate, which in this situation will use up the nil-rate band that becomes available to the rest of the estate after seven years.
Therefore, the estate itself will also be liable to additional IHT on death within seven years, and depending on the circumstances, a separate level term policy written in an appropriate trust for the estate legatees might also be required. Where an IHT liability will continue after any PETs or CLTs have dropped out of account, whole of life cover written in an appropriate trust can also be considered.