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SQE1 Basic Explanation of Inheritance Tax | BARBRI SQE Prep
BARBRI SQE Prep
Overview
This video explains the fundamentals of UK Inheritance Tax (IHT), often referred to as a 'death duty.' It covers when IHT is typically charged, primarily on death but also on certain lifetime transfers, and outlines a four-step process for calculating it: identifying the transfer of value, determining the value transferred, applying exemptions and reliefs, and calculating the tax. The explanation details how IHT applies to estates on death, including joint tenancies and gifts with reservation of benefit, and then shifts to lifetime transfers, distinguishing between potentially exempt transfers (PETs) and immediately chargeable transfers. It also touches upon the nil-rate band, residence nil-rate band, spouse exemption, charity exemption, business property relief, agricultural property relief, and the complexities of the seven-year rule for PETs and cumulative totals.
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Chapters
- Inheritance Tax (IHT) is primarily a tax on an individual's estate upon death, with a history in the UK dating back to the 1800s.
- It can also apply to certain gifts made during a person's lifetime to prevent avoidance of tax on death.
- Gifts made within seven years of death may be subject to IHT, as can immediate lifetime charges to companies or trusts.
- The calculation process involves four steps: identify the transfer of value, find the value transferred, apply exemptions/reliefs, and calculate the tax.
Understanding the basic scope and calculation framework of IHT is crucial for identifying potential liabilities and planning for estates, both for individuals and their beneficiaries.
Giving away £100,000 as a gift reduces your estate's value by that amount, making it a potential transfer of value for IHT purposes, unlike selling an asset for the same amount which merely swaps one form of wealth for another.
- On death, the entire estate is treated as a transfer of value, encompassing assets the deceased was beneficially entitled to, including joint tenancies (usually 50% share).
- Certain assets, like those subject to a 'gift with reservation of benefit' (e.g., giving a house but continuing to live in it), are included in the death estate.
- Assets like life insurance policies written into trust or discretionary pension lump sums may not form part of the death estate as they are paid directly to beneficiaries or at trustees' discretion.
- The value of assets is generally their open market value, potentially adjusted for factors like shareholding percentages, and liabilities like mortgages and funeral expenses are deducted to arrive at the net estate value.
Accurately identifying and valuing all assets and liabilities within the deceased's estate is the foundational step for any IHT calculation.
If someone gifts their house to their son but continues to live there rent-free, it's considered a gift with reservation of benefit and will be included in their estate for IHT purposes upon death.
- Transfers to a spouse or civil partner are generally exempt from IHT.
- Gifts to charities are exempt, and a significant charitable bequest (10% of the net estate) can reduce the tax rate on the remainder.
- Business Property Relief (BPR) and Agricultural Property Relief (APR) can provide 100% or 50% relief on qualifying business assets or agricultural property if owned for at least two years.
- These reliefs are policy-driven to support businesses, farming, and marital/charitable giving.
Understanding available exemptions and reliefs is critical for reducing or eliminating IHT liability, significantly impacting the amount passed to beneficiaries.
A qualifying trading business owned for over two years by the deceased would be eligible for Business Property Relief, potentially reducing its value for IHT purposes by 100%.
- The first £325,000 of an estate (the nil-rate band) is taxed at 0%.
- The nil-rate band is reduced by any chargeable lifetime transfers made within the preceding seven years.
- A transferable nil-rate band is available if a deceased spouse's nil-rate band was not fully used.
- The Residence Nil-Rate Band (RNRB) offers an additional allowance if a qualifying home is passed to a direct descendant, up to a certain value.
- Tax on the portion of the estate exceeding the available nil-rate bands is typically 40%, but can be reduced to 36% if at least 10% of the net estate is left to charity.
The nil-rate band and RNRB are the primary allowances that shield portions of an estate from IHT, making their correct application essential for accurate tax calculation.
If a deceased's estate is valued at £500,000 and they have used none of their £325,000 nil-rate band, the first £325,000 is tax-free, and tax is only calculated on the remaining £175,000 at the applicable rate.
- Potentially Exempt Transfers (PETs) are gifts between individuals; no tax is due immediately, but they become chargeable if the donor dies within seven years.
- Lifetime Chargeable Transfers are gifts to trusts or companies, immediately subject to IHT at 20% on amounts exceeding the nil-rate band (if available).
- Annual exemptions (£3,000) and small gift allowances (under £250) can reduce the value of lifetime transfers.
- Normal expenditure out of income and gifts in consideration of marriage are also exempt lifetime transfers.
- For BPR and APR on lifetime gifts, the recipient must still own the asset (or a replacement) on the donor's death.
Distinguishing between PETs and lifetime chargeable transfers is vital, as their tax treatment, timing of chargeability, and available reliefs differ significantly.
A gift of £10,000 to a child is a PET. If the parent survives for seven years, no IHT is due. If they die within seven years, it becomes chargeable and is added to the estate for calculation, potentially using up the nil-rate band.
- When a donor dies within seven years of making a PET, it becomes chargeable and is aggregated with the death estate.
- The 'cumulative total' considers all chargeable transfers (including PETs that have become chargeable) made within seven years of death, and potentially further back for lifetime chargeable transfers.
- This cumulative total determines how much of the nil-rate band is available for the death estate.
- Taper relief reduces the IHT payable on PETs that become chargeable if the donor survives for between three and seven years after the gift.
- For lifetime chargeable transfers, tax may need recalculation due to changes in the nil-rate band availability or the tax rate (from 20% to 40%).
The seven-year rule and the cumulative total are complex but essential concepts that link lifetime gifting to the final IHT calculation on death, often requiring retrospective adjustments.
If a gift was made 5 years before death, and the donor survives 3-4 years after the gift, 80% of the IHT that would normally be due on that gift (after considering the nil-rate band) is payable.
Key takeaways
- Inheritance Tax is primarily levied on death but can be triggered by lifetime gifts, especially those made within seven years of death.
- The core IHT calculation involves identifying the value transferred, applying exemptions/reliefs, and calculating tax against available allowances like the nil-rate band.
- Spouse/civil partner and charity exemptions are significant, as are Business Property Relief and Agricultural Property Relief for qualifying assets.
- The nil-rate band (£325,000) is the primary tax-free allowance, but its availability can be reduced by prior lifetime chargeable transfers.
- Potentially Exempt Transfers (PETs) are gifts between individuals that only become taxable if the donor dies within seven years.
- Lifetime Chargeable Transfers (to trusts/companies) are immediately taxable on amounts exceeding the nil-rate band.
- The cumulative total, considering gifts within seven years of death, is crucial for determining the final IHT liability.
- Taper relief can reduce the tax on PETs that become chargeable if the donor survives for a period between three and seven years after the gift.
Key terms
Inheritance Tax (IHT)Death DutyTransfer of ValueEstateNil-Rate Band (NRB)Potentially Exempt Transfer (PET)Lifetime Chargeable TransferGift with Reservation of BenefitSpouse ExemptionBusiness Property Relief (BPR)Agricultural Property Relief (APR)Residence Nil-Rate Band (RNRB)Cumulative TotalTaper Relief
Test your understanding
- What is the primary difference in tax treatment between a gift to an individual and a gift to a trust made during one's lifetime?
- How does the seven-year rule impact gifts made during an individual's lifetime?
- What are the main exemptions or reliefs that can reduce an estate's liability to Inheritance Tax?
- Explain the concept of the nil-rate band and how it can be affected by previous lifetime transfers.
- Under what circumstances might taper relief be available when a potentially exempt transfer becomes chargeable on death?