What is inheritance tax and how does it affect my will?

Inheritance tax, or IHT, is primarily a tax that takes effect on death. When a person dies, IHT is charged on the value of their estate subject to various exemptions and reliefs. The value of the estate is broadly assets less liabilities and includes certain gifts made whilst the person was alive (lifetime gifts).

It would appear therefore that the easy way to avoid liability for IHT would be to give as much away during one’s lifetime. However, IHT is charged on certain lifetime gifts or transfers if the donor dies within seven years of making the gift.

Such a gift is called a potentially exempt transfer because at the time when the gift or transfer is made, no IHT is chargeable. If the donor survives for seven years, no IHT is payable. If the donor dies within the period, some IHT will be payable on the gift or transfer. There is, however, an annual gift allowance: 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 make small gifts of up to £250 to as many individuals as you like tax-free. But, you cannot combine the annual allowance and the small gifts exemption. Gifts to someone getting married or registering a civil partnership are also exempt up to a certain amount. There is a possibility of carrying forward unused annual allowance from one tax year to the next, however the regulations for gifts made in the seven years before death are quite complex and if you need further clarification, you should get specific legal advice.

Liability for IHT on death

Who is liable for payment to HM Revenue & Customs and who is responsible for the payment are two separate issues.

HM Revenue & Customs is only concerned with payment of Inheritance Tax (IHT) and will look to those representing the estate, being the personal representatives (PRs) (those appointed to manage the estate) and trustees. Those who ultimately receive the property will also be liable with the PRs, but in practice, the tax is generally already paid to HM Revenue & Customs before the beneficiary receives the property. The IHT on some assets, however, may be paid by instalments on an annual basis for a period up to ten years. An example of such an asset is land and buildings. The PRs should ensure all instalments are settled upon sale or other disposal prior to final distribution of the estate.

The PRs are liable to pay IHT on property that falls into the estate (property which passes under the deceased’s will or intestacy – where someone dies without having made a valid will). They are also liable for tax on property that does not pass to the estate, but to which the deceased was entitled, such as property passing to a joint owner by survivorship. For more information on intestacy, see our article on Dying without a will.

Where the deceased dies within seven years of making a lifetime gift, the PRs will be liable to pay IHT. The person who received the gift is primarily liable for the tax, but if IHT is not paid within twelve months after the end of the month in which the transferor died, HM Revenue & Customs will look to the PRs who then become liable. The PRs are liable to pay the IHT only to the value of the assets they received or would have received but for their negligence.

IHT burden on death

Inheritance Tax (IHT) on estate property is treated as part of the general testamentary and administration expenses.

In most cases, unless the will indicates an intention to the contrary, IHT is paid from the residue of the estate, after payment of debts, expenses and any specific or cash gifts. Where the will is silent or in the case of intestacy (where someone dies without having made a valid will, (see ‘Dying without a will‘) like other expenses IHT is paid according to a prescribed order as mentioned previously. The burden of IHT therefore falls on the rest of the estate.

Where property passes outside the estate, the PRs still retain a responsibility to pay IHT, but they have the right to recover the IHT from the person in whom the property vests, for example, a surviving joint proprietor who acquired the property by virtue of having survived the deceased.

If a person is entitled to a life interest under a trust and the estate is liable to IHT in respect of the property, the burden of IHT falls on the trustees who are also liable to pay the tax and not the PRs.

How to calculate IHT on death

There are basically five steps involved in the calculation of IHT. They are the following:

• Identify the estate
• Value the estate
• Apply any relevant exemptions
• Apply any relevant reliefs
• Calculate tax at the appropriate rate

Identify the estate

A person’s estate is the total of all the property to which they are entitled, but certain property is excluded. An example of excluded property is a future interest which means that, although the beneficiary may ultimately have an absolute interest in a property, during their lifetime another beneficiary is entitled to the use of the property.

Trust property

Where a person is entitled to claim income from a property in trust, they have an interest in possession in trust property. This occurs where a property is left in trust for one beneficiary or a number of beneficiaries, but the income from the property is paid to another individual during their lifetime. That individual who receives the income is entitled to that income and on their death, the value of the property is included in their estate for tax purposes. Although the individual did not have control over the property on their death, the property is treated as part of their estate and tax will be payable out of the trust fund.

Property outside the estate

If the deceased took out a life assurance policy written in trust for a named beneficiary, the proceeds of the policy do not form part of their estate and therefore IHT will not be payable. The same principle applies to monies paid into a pension fund for the benefit of the deceased’s family.