Lifetime gift rules cause confusion

It is generally understood that lifetime gifts can be very effective in reducing the inheritance tax burden on an estate if the person making the gift survives it by seven years. However, some of the technical rules applicable to lifetime gifts are often misunderstood leading to unexpected and unwanted consequences.

The complexities of the rules can be illustrated by an example.

Anthony’s estate planning

Anthony is divorced with two children. He wishes to reduce the IHT liability on his £3 million estate and makes the following arrangements:

• In 2014 he makes an outright gift of £200,000 to his son, George, to enable him to buy a property.
• In 2016 he sets up a discretionary trust for his grandchildren with an initial gift of £125,000.
• Finally, in July 2019, he makes a gift of £200,000 to his daughter, Louise.

Anthony dies in March 2020 leaving his estate equally between his two children. His brother and sister are executors of the estate.

Anthony believed that the gifts to his children would taper in value after he had survived the gifts by three years. He has made no provision in his Will for the payment of IHT on any failed lifetime gifts and did not take advice before beginning his estate planning. He wished to treat his children equally and believed that he had done so.

The IHT position

Anthony has died within seven years of all of the gifts. Consequently, the two gifts to his children are failed potentially exempt transfers (PETs); the gift to the grandchildren’s trust was a chargeable transfer when made but this fell within his IHT nil rate band at the time so no immediate lifetime charge to IHT was due.

On Anthony’s death there is no IHT due on the gift to George as its value falls within Anthony’s IHT nil rate band. This is also the case with the gift to the trust. However, taper relief does not operate (as Anthony had believed) to reduce the value of these gifts. It in fact reduces the IHT payable on the gift and, as there was no IHT due on these first two gifts, they are brought into account at their full value when calculating the IHT on Anthony’s estate.

In addition, the grandchildren’s trust will be subject to IHT charges on every tenth anniversary of its creation and when capital leaves the trust. In calculating those charges the failed PET to George will be brought into account meaning that, as the trust fund grows in value, it is likely to become liable to pay IHT on those occasions. By comparison if the trust had been set up before the potentially exempt transfers then there would be no failed PETs to take into account. Consequently the trust would be unlikely to pay IHT at any point (unless the value of its assets did very well and exceeded the IHT nil rate band in force when the charges are calculated).

Disappointment for Louise

Louise is alarmed to discover that, as Anthony’s nil rate band was fully used by the gifts to her brother and the trust, the gift to her is fully chargeable to IHT with a tax bill payable of £80,000, which she is liable to pay. As Louise has no children she feels that her brother has unduly benefitted from their father’s estate.

George refuses to agree that the residue of the estate should pay the IHT due on the gift to Louise, which causes a falling out between the two siblings. Louise refuses to pay the IHT due on the gift to her. Having distributed most of the estate, Anthony’s executors find themselves personally liable (to the extent of Anthony’s estate’s assets) for the £80,000 due on the failed gift to Louise, with no statutory right of recovery from her.

The Law Society’s suggestions

The Law Society suggested in its response to a consultation on simplifying IHT that better information for the public might help, although whether that information would be digested and followed is another matter. The Society stated that taper relief should perhaps taper the value of the gift rather than the tax due and that executors should be given a statutory right of recovery against beneficiaries who fail to pay the IHT due on lifetime gifts.

In the meantime it is clear that even fairly straightforward tax planning can have the potential to cause problems, so we would recommend that your clients always seek advice.