Most people know, that if they make a gift and survive for 7 years that gift will usually be outside the scope of Inheritance Tax after those 7 years have elapsed. These are known as potentially exempt transfers (PETS).
For this reason many people gift assets to the next generation during their lifetimes in the hope of escaping a 40% Inheritance Tax charge when they die and, providing the person giving the gift doesn’t continue to derive a benefit from the asset gifted then this usually represents simple and effective Inheritance Tax planning.
But what if you don’t live for 7 years after making the gift? There is a measure called taper relief which reduces the tax payable on gifts once 3 years have elapsed from making the gift.
This taper relief works on a sliding scale with the tax on gifts reducing by 20% where the donor survives 3 to 4 years, by 40% where they survive 4 to 5 years, 60% where they survive 5 to 6 years, and 80% where they survive 6 to 7 years after making the gifts. This means that an Inheritance Tax saving is achieved after just 3 years.
However, a common misconception with taper relief is that it reduces the value of the lifetime gifts on death, whereas in actual fact, taper relief reduces the tax on the lifetime gifts, but not the value of those gifts. This is not the same thing, as when the estate calculation is made, the Inheritance Tax nil rate band (currently £325,000 per taxpayer, and with unused nil rate bands transferring to surviving spouses) is first applied to the lifetime gifts, and then the remainder to the estate upon death.
This means that any lifetime gifts valued below the nil rate band will not benefit from taper relief at all, and only the remainder of the nil rate band is available to use against the remaining estate upon death.
However, while the way in which taper relief works is often misunderstood, it is still a very valuable relief, particularly for higher value estates, and making lifetime gifts continues to be an effective planning tool.
The key things to remember therefore are that taper relief reduces the tax on lifetime gifts if the donor survives at least 3 years; it works on a sliding scale from years 3 to 7; there is usually no Inheritance Tax on lifetime gifts after 7 years have elapsed; but the relief only applies to the value of gifts over the Inheritance Tax nil rate band.