How to avoid the 14 year inheritance tax gifting trap

Think you only have to worry about the seven year rule to avoid inheritance tax when making gifts? Think again – a little known quirk in the system can trigger an HMRC probe going back as far as 14 years to claw back tax.

Fresh inheritance tax (IHT) concerns have been raised amid reports chancellor Rachel Reeves is planning on tightening the rules on gifting during an individual’s lifetime. One of the most common strategies to avoid inheritance tax is to make gifts.

The proposals reportedly under consideration are limiting the value of lifetime gifts that can be passed on IHT free, as well as looking at the taper relief rules that currently reduce the amount of inheritance tax due from 40% down to zero after seven years.

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Under the so-called ‘seven year rule’, if you give away something and survive seven years, it’s outside your estate for IHT purposes, meaning whoever you gave it to doesn’t have to pay inheritance tax on it after you die.

But in reality, if you gift to a trust, which is an increasingly typical financial planning strategy, the taxman could end up investigating gifts you made as long as 14 years ago – and demanding inheritance tax be paid on those.

Ian Dyall, head of estate planning at wealth management firm Evelyn Partners, said: “The inheritance tax treatment of making a gift is widely misunderstood, and more complex than most people realise.

“Many people believe that once seven years has elapsed from the time a gift is made then they can be ignored. That is true for outright gifts to individuals, but gifts made to trusts up to 14 years before a person’s death can affect the overall amount of tax payable.”

In separate articles we look at other ways to reduce your IHT bill and also common IHT myths.

What is the 14 year IHT rule and how does it work?

There’s no separate ‘14-year law’ in the tax code. The phrase comes from how the existing seven year rule on gifts can, in certain cases, make HMRC look back up to 14 years when calculating inheritance tax, if someone dies within seven years of making a gift.

Jude Dawute, managing director of wealth manager Benjamin House, explained: “Under the seven year rule, if you give away something and survive seven years, it’s outside your estate for inheritance tax purposes.

“If you die within seven years, the gift is counted back in, and tax of up to 40% can be due.”

In this case, the gift will firstly reduce the inheritance tax-free allowance – also known as the nil rate band, which could potentially be up to £1 million if the last surviving parent is passing assets to their children – available to the executors of the estate who are sorting out who owes what in terms of IHT.

Once the tax-free threshold has been completely used up – meaning the nil rate band has been reduced to zero – the recipient of the gift becomes liable for the inheritance tax owed on their gift. However, the rate which would apply to the gift reduces over time due to an allowance called ‘taper relief’.

Where the 14 years rule comes in is if, before that gift, you had made an earlier chargeable lifetime transfer (CLT) – typically a gift into a discretionary trust.

“Gifts to trust are treated slightly differently,” said Dyall.

“Firstly there may be a liability to inheritance tax at 20% at the time the gifts to the trust are made, if their value exceeds the nil rate band when added to any other gifts to trust within the previous seven years.

“Again, if the donor survives for seven years after the transfer to the trust, there will be no further liability for the trustees of the trust.

“However, the gifts don’t disappear. Their value will be taken into account when calculating the liability on any gifts made in the final seven years of the donor’s life.”

Consequently, if a gift to a trust (a CLT) was made in the seven years before your later gift to an individual – known as a potentially exempt transfer (PET) – and you die within seven years of the PET, HMRC adds the earlier CLT into the calculation.

“That means they’re effectively looking at gifts made up to 14 years before your death when working out the tax,” said Dawute.

For example:

• In 2015, you put £300,000 into a trust (CLT)
• In 2021, you give £200,000 to your daughter (PET)
• You die in 2025, four years after the PET

Because you died within seven years of the PET, HMRC looks at the 2015 trust gift too, since it was within seven years before the PET. That earlier trust gift may have already used up your tax-free allowance (nil-rate band), meaning more of the later gift can be taxed.

How to avoid the 14 year inheritance tax rule

The best way to avoid the effect of this 14 year inheritance tax rule is to separate large gifts to trust by seven years and a day from large gifts to an individual.

Additionally, Dawute recommends making maximum use of your inheritance tax gift allowances:

• £3,000 per year (plus one year’s carry-over) and the £250 small-gifts allowance per person are free of IHT
• Wedding gifts: up to £5,000 to a child, £2,500 to a grandchild/great-grandchild, and £1,000 to anyone else, given in connection with their marriage or civil partnership, are exempt
• Gift out of surplus income: regular gifts from surplus income are exempt if they don’t reduce your standard of living

You could also consider life cover. A ‘gift-inter-vivos’ life policy, written in trust, can insure the reducing tax risk during the seven years after a large gift.

Furthermore, it could be worth considering making outright gifts, which disappear after seven years, rather than gifts to trusts, which don’t.

Dyall said: “Trusts provide a very useful way of protecting money which has been gifted and retaining some control over it, but in many cases that control is unnecessary and restricts your ability to mitigate inheritance tax.

“The biggest barrier to minimising your inheritance tax liability is trying to maintain control over the assets you have. This leads to people leaving planning too late and limiting the amount they give during their lifetime.

“It’s important to ask yourself the question, ‘do you need all the assets you own and is retaining control or protecting those assets strictly necessary’, as that control could end up costing you more in inheritance tax.”