How Does Inheritance Tax Work?
Inheritance Tax is usually paid on an estate (all assets, less any liabilities) when somebody dies. There is a lifetime rate of Inheritance Tax, but that is only payable on certain gifts into a Trust or gifts to a corporate entity, not to an individual.
Most estates don’t have to pay Inheritance Tax because they’re valued at less than the threshold (£325,000 in 2017/18) (£425,000 if the Residential Nil Rate Band [RNRB] applies). The tax is payable at 40 per cent on the amount over this threshold or 36 per cent if the estate qualifies for a reduced rate as a result of a charitable bequest (minimum 10% of the estate).
Since October 2007, married couples and registered civil partners can effectively increase the threshold on their estate when the second partner dies – to as much as £650,000 in 2017/18 (£850,000 with the RNRB). Following the death of the first spouse or civil partner, their unused Inheritance Tax threshold or ‘Nil Rate Band’ can be transferred to the second spouse or civil partner when they die.
Inheritance Tax Exemptions
Sometimes, even if your estate is over the threshold, you can pass on assets without having to pay Inheritance Tax. Examples include:
- Spouse or civil partner exemption. Your estate usually doesn’t owe Inheritance Tax on anything you leave to a spouse or civil partner who has their permanent home in the UK – nor on gifts you make to them in your lifetime – even if the amount is over the threshold.
- Charity exemption. Any gifts you make to a ‘qualifying’ charity – during your lifetime or in your will – will be exempt from Inheritance Tax. A donation to charity in your will may also reduce the rate at which tax is paid.
- Potentially exempt transfers. If you survive for seven years after making a gift to someone, the gift is generally exempt from Inheritance Tax, no matter what the value.
- Annual exemption. You can give up to £3,000 away each year, either as a single gift or as several gifts adding up to that amount – you can also use your unused allowance from the previous year but you use the current year’s allowance first.
- Small gift exemption. You can make small gifts of up to £250 to as many individuals as you like tax-free.
- Wedding and civil partnership gifts. Gifts to someone getting married or registering a civil partnership are exempt up to a certain amount.
- Gifts out of income. Any regular payments made to someone that are demonstrably affordable out of income, i.e. the Donor still has adequate income to maintain their standard of living, are exempt.
- Business, Woodland, Heritage and Farm Relief. If the deceased owned a business, farm, woodland or National Heritage property, some relief from Inheritance Tax may be available.
How does Inheritance Tax work?
On death everything the person owns has to be valued – property, personal possessions, cash, savings, investments, etc – including their share of items owned jointly with somebody else. From this is deducted any liabilities outstanding at the date of death – mortgage, household bills, credit cards, etc – and the cost of the funeral, to arrive at the net total. The taxable amount is then arrived at by deducting any of the Allowances/Exemptions referred to above and the relevant Nil Rate Band.
Care needs to be exercised with the value of certain gifts, as the legislation stipulates that the value is related to the reduction in the overall size of the Donor’s estate. For example, someone who owns a pair of Ming vases decides to give one away and keep the other; each vase is valued at £300,000, but the pair would command £1,000,000 at auction. The value of the gift is not £300,000, but £700,000, as this is the effective drop in the overall value of the estate.
Who will have to pay Inheritance Tax?
On an estate, it’s the Personal Representative – Executor if there’s a Will or Administrator if there is none. In a Trust, it’s the Trustee. The tax is deducted from the funds held by the Personal Representative or Trustee, so it comes out of the beneficiaries shares in the end, but anything received by way of an inheritance is already tax-paid. However, there may be some Income Tax and/or Capital Gains Tax to pay, but this is generally fairly minor.
Great care needs to be exercised by those receiving a lifetime gift, particularly a fairly substantial sum, which would be classified as a “Potentially Exempt Transfer” (see above), as you could be faced with an Inheritance Tax liability if the Donor dies within 7-years. This could be potentially embarrassing if the money has already been spent! All recipients of such gifts should consider insuring the life of the Donor against this eventuality.
If you believe you have an Inheritance Tax problem and want to know what legitimate steps you can take to mitigate this, contact me today, or complete the form below.