Few areas of inheritance tax planning cause more confusion than the notorious IHT "14-year rule".

Gifts made more than seven years before death are normally free of IHT, but certain older gifts can still increase the tax due on later gifts made within seven years of death.

With advisers showing a growing interest in lifetime gifting to counter inflated taxable estates once pensions are included from April 2027, it is essential to understand the impact new gifts may have for clients with a history of gifting.

A knowledge of how the 14-year rule works will help clients with the timing and value of gifts to achieve better IHT outcomes. In certain circumstances, clients may still wish to cap the amount they gift or defer gifting until a later date. But in others, there may be scope to safely make larger gifts.

Making lifetime gifts

Gifts made during lifetime fall into three types; exempt, chargeable lifetime transfers (CLTs) and potentially exempt transfers (PETs).

When gifting consists of only making CLTs into discretionary trusts, most clients will want to keep the seven-year cumulative value of CLTs to below the nil rate band. If they exceed the nil rate band, there will be an immediate lifetime charge on the excess of 20%.

However, if a client wishes to gift more than the nil rate band, they may consider making direct gifts which qualify as PETs. These will never attract a tax charge during the donor's lifetime and will be exempt once the donor has survived seven years. If the donor dies within seven years, the PET becomes chargeable and this may impact on IHT payable. But how?

IHT calculations on death

Essentially, there are two calculations on death – one for the tax on the estate itself, and the other on each 'failed' gift made in the last seven years.

IHT on the estate

The tax on the estate is broadly the value of the estate less any available nil rate band. This includes the residence nil rate band and any transferable residence nil rate band and nil rate band from a deceased spouse or civil partner.

The available nil rate band will be reduced by all the chargeable transfers, including PETs that become chargeable, made in the seven years before death. Any gifts older than seven years can be ignored – the '14-year rule' does not apply here.

IHT on lifetime transfers

We must also revisit each lifetime transfer in turn for the seven years prior to death, including PETs that have now become chargeable, to see what tax would have been paid at the time they were made. This could pick-up chargeable transfers in the seven years prior to the transfer in question. This is where the '14-year rule' originates. Chargeable transfers made up to 14 years before death can still influence IHT payable.

Each transfer is looked at in isolation and a separate calculation performed, using the current nil rate band and any available transferable nil rate band each time. However, the residence nil rate band cannot be used with lifetime transfers.

Taper relief may reduce the final amount of tax paid on lifetime transfers made more than three years before death. Remember that if the cumulative value of the transfers is within the available nil rate band, then there will be no tax on the transfer in question.

Example

Alec is a divorcee and parent of two children, Jack and Jill, and grandfather to 5 grandchildren.

His gifting history, starting with the earliest year first, is as follows:

Year 1 – £300,000 into a discretionary trust (CLT)
Year 4 - £100,000 gift to Jack (PET)
Year 7 - £50,000 gift to Jill (PET)
Year 9 - £75,000 into discretionary trust (CLT)
Year 13 - Alec dies with estate of £800,000 (including family home valued at £400,000).

The whole estate is to be split between his two children.

(Assume the gifts are made on the same date each year and the £3,000 annual allowance is already used).

IHT on the estate:

We are only concerned with the estate owned by Alec on death and transfers made in the seven years before death. All other transfers can be ignored. This picks up the transfers in year 9 (£75,000 CLT) and year 7 (£50,000 PET to Jill).

Alec is entitled to a nil rate band of £325,000 and the residence nil rate band of £175,000. However, his standard nil rate band of £325,000 is used by the two lifetime transfers first, with any balance available to the estate. As the total of lifetime transfers is £125,000, there will be no IHT on these, leaving £200,000 of nil rate band available to the estate. Note: lifetime transfers do not reduce any residence nil rate band.

The tax on the estate is (£800,000 - £200,000 - £175,000) x 40% = £170,000.

IHT on the failed lifetime transfers:

We must also look back to re-assess what tax would have been paid on each chargeable transfer in the seven years before death. A new calculation is done on each transfer to work out what tax would have been paid at the time the gift was made but using the full current nil rate band and at the IHT death rate (i.e.40%).

Therefore, the transfers in scope are the year 7 gift to Jill and the year 9 gift into discretionary trust.

The transfers made in years 1 and 4 do not need to be revisited because they were made more than seven years before death.

Analysis

The total IHT payable is £172,000 (£170,000 plus £2,000).

Had the gift to Jill in year 7 been limited to £25,000, there would have been no tax on it, but then there would have been an extra £25,000 in the estate. Ignoring growth, this would have resulted in £10,000 additional tax.

However, if the gift to Jill had been delayed by a year it could have avoided tax altogether by ensuring there was more seven years between the gift to Jill and the original £300,000 gift into trust.

Of course, this must be balanced against the likelihood of the client surviving their gifts by seven years – the earlier a gift is made, the sooner it will be outside the estate altogether.

Other considerations

Returning to the example, what if Alec had been widowed several years ago? If none of his late wife's nil rate band had been used on her death, it would be available to Alec when calculating the IHT on his estate and when revisiting each of the lifetime transfers.

There would have been no tax on the estate as the total nil rate band (including the residence nil rate band) is £1,000,000 compared to the estate value (including lifetime gifts) of £925,000.

With regards to IHT on the two lifetime gifts in years 7 and 9, a nil rate band of £650,000 (do not include the residence nil rate band here) would have been available for each retrospective calculation, and so there would have been no further tax on these either. In fact, this time there would have been scope to make a larger gift to Jill.

Summary

Unfortunately, advice will be different for each client's circumstances – there is no 'one size fits all' solution.

The '14-year rule' does not automatically mean that gifting should be ruled out just because a gift was made into a discretionary trust within seven years of a later gift. It will have to be considered, but there may or may not be any impact. Unfortunately, this does involve number some crunching.

Ultimately, effective planning requires more than simply comparing the tax payable now with the tax that might arise on death. The donor's health, the likelihood of surviving the gift, the availability of taper relief and access to nil rate bands can all influence the outcome. Considering these factors together will help ensure the chosen approach is both tax-efficient and appropriate for the client.