AA Legal Documents

Inheritance Tax

Contents

When a person dies, their estate may be subject to payment of Inheritance Tax, depending on the value of the estate and to whom the assets are left.

If the entire estate is left to the surviving spouse/civil partner or a registered UK charity, no Inheritance Tax (IHT) will be payable.

Principles

Lifetime gifts

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. It may also be charged on other assets even if given away more than seven years before death, for example if the donor had reserved a benefit for themselves. An example would be where somebody had given away their house but continued to live in it rent-free.

A lifetime gift to another person 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. 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 executors (those appointed to manage the estate) and trustees. Those who ultimately receive the property will also be liable along with the executors, 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 executors should ensure all instalments are settled upon sale or other disposal prior to final distribution of the estate.

The executors 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. For more information on intestacy, see our article on Dying without a 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.

Where the deceased dies within seven years of making a lifetime gift, the executors 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 executors who then become liable. The executors 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 executors 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 liferent 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 executors.

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.

Pension funds

If the deceased was a member of a pension fund with a discretionary death benefit, that sum will not be paid to the estate and is not counted for IHT purposes. The deceased may have been able to nominate somebody to receive that benefit by completing a form and giving it to the pension fund trustees.

Two people dying simultaneously

If two people die together and there is no evidence of the order of their death, for the purposes of who will receive the assets, the normal rule is that the younger is said to have survived the older. There are exceptions:

  • Where the elder has made a Will leaving estate to the younger but specifying what happens if the younger dies first and the younger has made no Will – here the elder will be deemed to survive the younger
  • Spouses and civil partners are also exceptions to the normal rule – here, neither is deemed to survive the other
For the purposes of IHT, however, the deaths are presumed to occur at the same instant. By way of example, John leaves property in his Will to his younger brother James who in turn leaves the property in his Will to his children. If John and James die in a motor accident and it is not possible to establish the order of death, the property will pass from John to James and thereafter to James' children. For IHT purposes, the property left by John to James will be taxed as part of John's estate and not part of James' estate.

Value of the estate

Assets in an estate for IHT purposes are valued at the open market value. It is 'the price which the property might reasonably be expected to fetch if sold in the open market'. Generally, assets are not difficult to value, but in the case of land, it may be necessary to negotiate a value with the District Valuer (a civil servant) and a chartered surveyor's valuation is normally obtained for this purpose. The value immediately before death of every asset forming part of the estate for IHT purposes must be assessed and reported to HM Revenue & Customs in the Inheritance Tax account.

Application of valuation principles

The value placed on bank and building society accounts is the balance as at the date of death including interest accrued up to the date of death.

The value of quoted shares is taken from the Stock Exchange Daily Official List for the date of death. To value the shares for IHT, take one quarter of the difference between the lower and higher price and add it to the lower price.

It is more difficult to value unquoted shares. The principle of the open market value will apply and information will be required about the company. A value will generally be obtained from the company accountant.

It is relatively straightforward to reach a value where the deceased owns an entire house or piece of land. As mentioned, a value may have to be negotiated with the district valuer. Generally, the executors will seek a chartered surveyor's valuation for the purpose of completing the IHT forms, including the Inventory of the estate. Where the deceased owned a share of the property, the value of the whole property is taken and divided by the number of shares. A discount of 10-15% in the value of the property is normally allowed to reflect the fact that a part interest will be far more difficult to sell. The discount will not be permitted in the case of a husband and wife (or civil partners) co-owning the property.

Specific rules apply where the parties are related. Property owned by spouse/civil partners is worth more valued together than separately. Each spouse/civil partner's share of the property must be valued not in isolation, but as a proportion of the whole. For example, a husband and wife each own 35% of the shares in a company and the husband dies. His share for IHT purpose is not valued as 35% of the company but half of 70% to reflect that a 70% shareholding will be worth more, as it gives control of the company.

Debts owed by the deceased

Liabilities owed by the deceased at the time of death reduce the value of the estate for IHT purposes. They include general household bills and any outstanding income tax. Furthermore, the funeral account, memorial account and 'reasonable' after-funeral expenses may be deducted.

Apply any relevant exemptions

Spouse/civil partner exemption

All property forming part of the estate for Inheritance Tax (IHT) passing to the deceased's spouse/civil partner either under the Will or according to the intestacy rules (see 'Dying without a Will') is exempt (i.e. taxed at 0%). No IHT will be payable irrespective of the value of the assets. This basic rule also applies to an interest in a house, for example, such as the person who has a right to the income. If that interest is left to the surviving spouse/civil partner, it is exempt. Where the deceased leaves his estate to trustees on trust to pay the income to his spouse/civil partner for life and on his/her death to his children, the spouse/civil partner exemption applies on the first death.

For deaths after 9 October 2007, if the deceased had a spouse or civil partner who had predeceased them leaving all or part of their nil rate band unused, the percentage portion unused can be added to the nil rate band available on the second death. If, for example, the first spouse died in 2000 and all of his assets passed to his surviving spouse (i.e. saving 100% of his nil rate band), on her death in November 2008, her nil rate band will be inflated by a further 100%, in effect doubling her nil rate prevailing in November 2008. This can be advantageous particularly if the nil rate band has increased in the interval between the two deaths.

Charity exemption

Any property forming part of the deceased's estate which passes on death to a UK registered charity is exempt from IHT. Gifts to certain national bodies, such as museums and art galleries, may also qualify for a similar exemption.

Apply any relevant reliefs

In addition to the exemptions, certain relief from IHT may be granted in respect of the transfer of business and agricultural property both during the owner's lifetime and on death.

Business property relief

If the deceased owned business property for a period of two years or more prior to transfer, it may be eligible for tax relief.

Business property relief of 100% is available for a business or partnership share or unquoted shares (private company). The business must be a trading business and not a wholly, or mainly, investment business.

Business property relief of 50% is available in the case of quoted shares (provided the transferor had control of the company immediately prior to the transfer) and land, buildings, plant and machinery where the transferor was a partner or in control of the company.

For the purposes of calculating IHT, the value of the property will be reduced by either 100% or 50%.

Agricultural property relief

Where the transferor occupied agricultural property throughout the two years prior to the transfer or he owned the agricultural property throughout the seven years immediately before the transfer, agricultural relief will apply.

Agricultural relief of 100% is available where the transferor had the right to vacant possession immediately before the transfer or let the land under a lease after 1 September 1995.

Agricultural relief of 50% is available on any other qualifying agricultural property.

Calculate tax at the appropriate rate

The rates of tax applicable on death are currently:

  • 0% on the first £325,000 (nil rate band for tax year 2013/14)
  • 40% on the balance of the estate on death
Cumulation

All assets must be taken into account before one is able to commence calculation of the IHT payable. This includes immediately chargeable lifetime transfers and potentially exempt transfers that have become chargeable as a result of the transferor dying within seven years of making the gift. The cumulative total will then be calculated.

The nil rate band is then applied to the first £325,000 and the balance of the estate, if any, will be chargeable to IHT at the rate of 40%.

Estate rate

Estate rate means the average rate of tax applicable to each item. Sometimes it is important to work out how much tax is attributable to particular items of property. The executors may be paying tax on the land by instalments or the executors are not liable for all the tax as would be the case where a gift is left to the beneficiary 'subject to tax'. The basic principle therefore is that the tax is divided between the various assets in the estate proportionately, according to their value.

Quick succession relief

If the deceased received property under a chargeable transfer made to them within five years before they died (the first transfer), relief is available to reduce the amount of tax payable by a percentage of the tax paid in respect of the first transfer. The amount of the reduction varies according to the number of years between the transfer and the death. The closer the transfer to the death, the greater is the reduction in tax payable.

Where the first transfer was made in the year before death, the reduction is 100%, 1-2 years before death and it is 80%, down to 20% between years 4 and 5.

Relief only applies where tax was paid on the first transfer and tax is payable on the deceased's estate.

Time for payment

Non-instalment option property

The Inheritance Tax (IHT) payable on the property in the estate that does not attract the instalment option is due for payment six months after the end of the month of death. This is known as the due date. If payment is made thereafter, HM Revenue & Customs will be entitled to interest on the amount outstanding.

At the same time as they deliver the Inheritance Tax account, the executors must pay the IHT on the property which does not have the non-instalment option. The account must be delivered within twelve months of the end of the month of death. Without payment of the IHT, Confirmation cannot be obtained. In the circumstances, the executors will usually submit the account as soon as possible and pay the IHT before the due date.

Instalment option property

If property in the estate qualifies for the instalment option, the executors can elect to pay the IHT in respect of that property in ten equal yearly instalments. The first instalment is payable six months after the end of the month of death.

Property qualifies for the instalment option if it is:

  • Land
  • A business or interest in a business
  • Shares (quoted or unquoted) where the deceased had control of the company immediately prior to their death
  • Unquoted shares which do not give control if either the holding is sufficiently large (10% of the nominal value of the shares and worth more than £20,000) or HM Revenue & Customs is satisfied that tax cannot be paid in one lump sum or IHT attributable to the shares or other instalment option property in the estate amounts to at least 20% of the IHT payable on the estate
Interest

Interest on the instalment option property comprising of land is payable with each instalment apart from the first, on the amount that was outstanding the previous year.