Inheritance tax – that seven-year rule – what it’s all about? Tim Mullock

Have you started thinking about estate planning? Let’s hope you have. If the answer’s ‘no’, then today is as good a time as any. And there’s no better way to start than by looking at the famous ‘seven-year rule.

Gifts and inheritance tax

Certain gifts can be subject to inheritance tax – usually at a rate of 40%. You might think that the simple way to avoid your beneficiaries having to pay inheritance tax is for you to give everything away before you die. Not so fast. HMRC has applied a set of rules to stop you from doing exactly that.

Some gifts are usually tax-free from the moment you make them. For example, gifts between you and your spouse or civil partner, or the first £3,000 you give in each tax year. However, other gifts can result in an immediate tax bill immediately or further down the line. To find out more about these, get in touch, and we’ll talk you through your options.

The seven-year rule

Let’s look now at gifts that aren’t immediately tax-free but which HMRC considers ‘potentially exempt transfers’. In other words, they’ll only be tax-free if you survive for at least seven years after making the gift. If you die within that time, your beneficiaries may find themselves paying inheritance tax.

Your nil-rate band

So, we’ve agreed that, if you die within seven years of making a potentially exempt transfer, the transfer becomes chargeable. Its value will either reduce or eliminate your nil rate band (the amount which can be passed to your beneficiaries without inheritance tax liability). This band is usually £325,000 per person.

An example

■ In May 2016, Stanley Shirtcliffe gifted £100,000 to his daughter, Hannah.

■ Four years later, in June 2020, Stanley died and left, after inheritance tax, his remaining estate of £650,000 to Hannah and her brother in equal shares. Because he’d died within seven years of making the gift, its value reduced his nil rate band.

■ This meant Hannah would receive her £100,000 gift tax free, leaving £225,000 which could then be passed to her and her brother tax-free.

■ The remaining value of his estate was £425,000 (£650,000 – £225,000).

■ This was subject to inheritance tax at 40%.

■ The total Inheritance tax bill was, therefore, £170,000 (£425,000 x 40%).

■ The consequence is that the net estate (tax paid) was paid to Hannah & her brother £240,000 each.

You might think that the simple way to avoid inheritance tax is to give everything away before you die…

Giving away more than the nil-rate band

If you die within seven years of making gifts that exceed the nil-rate band, your full nil-rate band will be used up by the gift. When you die, there will be none left – your beneficiaries will pay 40% on their entire inheritance.

On top of this, the recipient of the gift may need to pay inheritance tax on the value of the gift above the nil rate band. However, the news isn’t all bad. The amount of tax they will pay depends on how long you survive after making the gift.

What is taper relief?

The rate of inheritance tax they will pay gradually reduces over the seven year period – this is called taper relief. Here’s how it works:

Taper relief only applies to the amount of tax your beneficiaries pay on the value of the gift above the nil rate band. For the remainder of your estate, they will have to pay the full rate of inheritance tax – usually 40%.

An example

■ In June 2014, Helen Jones gave her son, Sean, £500,000.

She died six years later in July 2020, leaving Sean the rest of her £700,000 estate. She had gifted more than her nil rate band. So, when she died, Sean had to pay inheritance tax on the excess.

■ Inheritance tax was due on the value of the gift above the nil rate band, which was £175,000 (£500,000 – £325,000).

■ Because Helen had died six years after making the gift, taper relief kicked in. The amount of inheritance tax due was reduced by 80%.

■ So, rather than paying the full £70,000 (£175,000 x 40%),

Sean only had to pay £14,000 (£70,000 x 20%).

■ The gift made in 2014 had used up Helen’s nil-rate band.

The result was that her entire estate was also subject to inheritance tax at the usual 40%. An inheritance tax bill of £280,000 (£700,000 x 40%) had to be paid before Helen’s assets could be released to her son.

■ When looking at your estate planning and making financial gifts, some of the areas to consider are:

❙ how much money you can afford to gift without incurring inheritance tax for your beneficiaries ❙ whether you’re due to leave behind an inheritance tax bill, and how best to manage or reduce this ❙ whether you’d be better off making outright gifts or setting up a trust

How long ago was the gift made? How much the tax reduces

0-3 years No reduction

3-4 years 20%

4-5 years 40%

5-6 year 60%

6-7 years 80%

More than 7 years No tax to pay