Inheritance Tax (or IHT as it is commonly abbreviated to) was introduced in 1986 to replace Capital Transfer Tax, which had been in force for the previous 12 years. IHT is less onerous than the previous CTT regime in that most lifetime transfers are no longer subject to an immediate tax charge. However, the rules have also been tightened up considerably over the last 20 years so that previous loopholes, such as gifts with reservation of benefit and certain types of trust, can no longer be used effectively as tax planning tools.
IHT applies to the following:
a) the estates of deceased persons
b) chargeable lifetime transfers (CLTs)
c) potentially exempt transfers (PETs) within the last 7 years
d) trusts subject to principal charges or proportionate charges
Certain types of gift that avoid an immediate IHT charge may however create a possible exposure to Capital Gains Tax, so it is important to consider the interaction between taxes when planning an effective tax mitigation strategy.
IHT is levied at a flat rate of 40% on all taxable estates. As mentioned above, most lifetime transfers of assets are not immediately taxed as they are deemed to be potentially exempt. These are known as PETs and are only taxed if the transferor dies within 7 years, in which case they are added to the value of the estate. However, a gift may be immediately taxable if it is a Chargeable Lifetime Transfer. In that case, it will be subject to an IHT charge of 20%.
Assets held in trusts may also be subject to IHT at various times. Please see our information sheet on Discretionary Trusts for an explanation of periodic and exit charges.
It is the responsibility of the executors to ensure that the correct amount of IHT is paid on the estate of a deceased person. This is done by completing Form IHT205 (2006) or Form IHT400. One of these forms must be filed within 12 months of death and any IHT liability must be paid before Probate (or Letters of Administration if the deceased died intestate) can be granted.
The executors should file Form IHT205 (2006) if it is an excepted estate. This will normally be the case in the following circumstances:
a) the estate is less than the current nil rate band (£325,000 for 2009/10); or
b) the estate is less than £1 million and no IHT is payable due to spouse, civil partner or charity exemption
There are various other conditions that must be satisfied in order for it to be an Excepted Estate such as no gifts worth more than £150,000 within the last 7 years and no assets outside the UK worth more than £100,000.
Form IHT205 (2006) is used for excepted estates and consists of 4 pages requiring basic information about the deceased and his/her estate. Most of these are simple Yes/No questions aimed at confirming that it is an excepted estate. The executors must also provide details of the following:
a) an analysis of the estate to confirm its gross value for IHT purposes
b) an analysis of funeral expenses and any debts that may be owed by the estate
c) an analysis of exemptions for assets passing to a spouse, civil partner or charity, etc
This will give the net qualifying value of the estate for IHT. If that figure turns out to be higher than the current nil rate band, the executors must ditch this form and complete Form IHT400 instead.
If it later transpires that something is missing or the figures have changed, it is only necessary to inform HM Revenue & Customs if the net value of the estate (before exemptions) is higher than the nil rate band in force at the time of death and there are insufficient exemptions to avoid an IHT liability. The executors must then list any new items or changes in a Corrective Account (Form C4) and send it to HM Revenue & Customs with a cheque for the IHT liability.
Form IHT400 must be used for any estate that does not meet the definition of an excepted estate. It does not necessarily follow that there will be an IHT liability if an estate is non-excepted, and if a spouse or charity exemption applies it is quite possible that there wont be. Nonetheless, it is still necessary to complete this 16 page form plus various supplementary schedules.
The form requires a much more detailed analysis of the estate and a calculation of the IHT liability. This liability can normally be worked out by completing the Simple Inheritance Tax Calculation on page 11. However, in certain situations the executors must use Form IHT400 Calculation instead, such as when the total of any lifetime gifts is above the IHT threshold, the IHT liability will be paid more than 6 months after death or if the executors wish to pay by instalments. The executors are also required to provide various other documents, such as professional valuations, insurance policies and business accounts.
It should be noted that interest will be charged on any IHT liability that is not paid within 6 months of death, regardless or whether or not Probate has been granted and even when the executors are allowed to pay by instalments (except when IHT is due on a business or a farm). In any case, payment by instalments is only allowed when it is necessary to sell certain types of asset such as land and property in order to pay the IHT bill. Instalments are also allowed when IHT is due on a lifetime gift, although the balance is due immediately if the asset is later sold.
Chargeable Lifetime Transfers
As mentioned above, a Chargeable Lifetime Transfer (CLT) is any gift made whilst the donor is still alive that does not qualify as a Potentially Exempt Transfer (PET). Unless a CLT qualifies as an excepted transfer, the donor or transferee is required to complete Form IHT100 together with Form IHT100a within 6 months of the transfer date. General information on how to complete these forms can be found on Form IHT110.
Form IHT100 is also used by trustees to report other types of chargeable event, mainly affecting trusts, such as:
a) the termination of an interest in possession (Form IHT100b)
b) trust assets ceasing to be relevant property (Form IHT100c)
c) principal charges on the 10 year anniversary (Form IHT100d)
d) assets ceasing to be held on special trusts (Form IHT100e)
e) cessation of conditional exemption (Form IHT100f)
f) alternatively secured pension funds (Form IHT100g)
It is necessary to use one of the supplementary forms referred to above depending on which type of transaction you wish to report.
The taxation of trusts is a very complicated subject beyond the remit of this particular information sheet. Some basic details are shown on our Discretionary Trusts information sheet, but it is always best to seek professional advice when dealing with trusts of any kind and absolute reliance should never be placed on information that may have been necessarily abridged due to the length of the subject matter.
Income from Estates
Finally, it is necessary to consider income received after death that is derived from assets forming part of a deceased persons estate as the tax treatment will depend on the nature of the income. Income received before death should always be taxed on the deceased person and included in his/her final tax return. If that income then forms part of the value of the estate at the date of death, then it would of course be subject to IHT as well, but personal representatives never incur an income tax liability in respect of interest, dividends, rent, etc received before death. It should be noted in this respect that it is when the income was actually received that counts, not when it was earned.
Income received after death is different. This will always be taxed on the personal representatives and they must ensure that any tax payable on the income is accounted for before it is distributed to the beneficiaries. Note that income does not include the repayment of debts owing to the deceased at the time of death. Such debts should always be included in the value of the estate, unless they were informal loans between individuals with no written agreement or other means of validation.
Once income has been distributed from an estate to a beneficiary, it then forms part of the taxable income of the beneficiary and must be declared on his/her tax return if he/she is required to file one. The personal representatives must therefore send the beneficiary Form R185 (Estate Income) at the end of each tax year in which a sum is distributed, as calculated according to the guidance notes. The form shows the type of income distributed and the amount of tax deducted. It also shows the beneficiary how to claim any tax rebate that may be owing to him/her. Note that the personal representatives cannot reclaim any tax deducted on such income themselves, but the beneficiaries may be able to apply for a rebate depending on their own tax position.