The subject of gifting money, trusts, and Inheritance Tax (IHT) appears relatively straightforward on the surface. It is only when you start to look at timings, Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs), that complications may arise. To be clear, there are tax-efficient ways to gift money to a trust to avoid/reduce your inheritance tax bill. However, there are several issues to be aware of.
Different types of transfers
For the moment, we will set aside the standard personal allowances and concentrate on the two main types of gifted money/asset transfers and the benefit of leaving part of your estate to charitable causes.
Potentially Exempt Transfers
Commonly referred to as PETs, this is a type of monetary or asset gift made to an individual (or in some cases a trust), which will be exempt from IHT if those making the gift survive for a further seven years.
Chargeable Lifetime Transfers
This type of transfer (into a trust) is usually described as a CLT and should be considered in line with long-term tax planning. The effective CLT nil rate band is £325,000 after which there will be IHT considerations. The CLT limit is effectively refreshed every seven years.
If an individual leaves more than 10% of their estate to charity, they will automatically qualify for a reduction in the headline inheritance tax rate, down to 36%.
CLTs and PETs would typically be free of potential inheritance tax if the donor survives at least seven years from the transfer date. If they were to die within seven years, and the estate was above the inheritance tax threshold of £325,000, tax relief would be tapered as follows:-
|Time between the date of transfer and date of death||Potential IHT tax charge||Percentage of full tax rate applied|
|In the first three years||40%||100%|
|3 to 4 years||32%||80%|
|4 to 5 years||24%||60%|
|5 to 6 years||16%||40%|
|6 to 7 years||8%||20%|
We have also added the far right column to the table to show the discounted percentage of the full tax rate, which would still apply if the 40% IHT rate was adjusted in the future.
Gifting money to a trust
It is important to recognise that different trusts have different aims and structures, but all will have a settlor/trustor, trustee and beneficiary. You should take professional financial advice before setting up a trust and when looking to gift money in the most tax-efficient manner.
Utilising your nil rate band
At the time of writing, each individual has what is known as a CLT nil rate band which currently stands at £325,000. This is the maximum seven-year cumulative amount that can be transferred into a trust without any IHT liability. Theoretically, you can move up to £325,000 into one or more trusts every seven years.
As discussed above, if you die within seven years of cash/asset transfers, they will be drawn back into your estate for IHT purposes although taper relief may be applicable. If, for example, you only made one CLT of £325,000 into a trust and lived for more than seven years after the transfer date, this could not be drawn back into your estate on death.
Each person also has an annual gift allowance which allows them to gift up to £3000 each tax year. This can be one gift of £3000 or split between several parties. When the funds have been transferred, they are the full possession of the beneficiary, and they can’t be drawn back into your estate.
It is also important to note that you can use the gift allowance for the current tax year and carry forward any unused allowance from the previous tax year. Therefore, if you have not used your gift allowance for the two tax years you could make gifts totalling £6000.
Utilising both allowances
If you have not used your CLT nil rate band allowance in the previous seven years or made any gifts in the current and previous tax year, you could gift a total of £331,000 into a trust with no immediate tax obligation. Obviously, the situation would change regarding the CLT if you were to die within seven years.
Settling any inheritance tax liability
When looking at a CLT and PET, there appears to be a degree of overlap, which can be confusing. However, it is crucial to recognise the difference, because the inheritance tax liability is allocated to different parties.
Where PETs are drawn back into the deceased’s estate because they died within seven years of the transfer date, the recipient pays any inheritance tax liability on that element. Where an IHT liability occurs with a CLT, this is paid by the settlor, i.e. the donor of the gift, their estate.
Timing is the key
To demonstrate the potentially complex nature of gifting money to individuals and trusts, it is crucial to appreciate the difference between a CLT and a PET.
Transaction 1: Mary transfers £300,000 into a trust (CLT) for the benefit of her child Stephen
Transaction 2: Six years and 364 days later, Mary makes an additional £200,000 gift to Stephen
Death: Six years and 364 days later, Mary passes away
In this scenario, the gift of £200,000 falls within the seven-year period and is therefore deemed a failed PET. To calculate the inheritance tax payable, we need to go back seven years from the £200,000 payment to see what element of the CLT allowance had been used. If no part of the CLT nil rate band had been used in the previous seven years, then the £200,000 would count towards this, and there would be no inheritance tax to pay.
As £300,000 of the total £325,000 CLT allowance had been used, only £25,000 could be brought forward and offset against the £200,000 gift. Consequently, this would create a chargeable gift of £175,000 against which inheritance tax could be charged, depending on the situation.
In this scenario, if Mary had waited just one more day before transferring the £200,000 gift to Stephen, the original CLT allowance would have been reset to £325,000. As a consequence, the £200,000 failed PET could have been offset against the reset CLT allowance.
Chargeable lifetime transfers above £325,000
If you were to transfer £500,000 into a trust as a CLT, with no other transfers in the previous seven years, this would exceed the nil rate band by £175,000. In this situation, the settlor (the person transferring the cash into the trust) would be liable to a partial 20% inheritance tax charge. This equates to £35,000 and would be taken into account as a credit against any additional IHT liability on the settlor’s death.
As you can see, the subject of gifting money to trusts, and individuals, as a means of avoiding inheritance tax can be relatively complex. In the above example, not delaying the £200,000 gift by just one day created a chargeable transfer of £175,000. This would be added to the deceased’s estate to calculate any inheritance tax liability. Waiting just one extra day would have brought the failed PET under CLT regulations and ensured the gift remained outside of the individual’s estate.
You must take professional financial advice when setting up trusts and considering gift transfers via CLTs and PETs.