A Potentially Exempt Transfer (PET) lets you gift assets and avoid inheritance tax if you live for 7 years after the gift. Understanding PETs can help you plan your estate to reduce tax. In this article we’ll look at what PETs are, the conditions and how they affect inheritance tax planning.

Summary

• Potentially Exempt Transfers (PETs) are exempt from inheritance tax if the donor survives 7 years after the gift, so estate planning strategies.
• Timing of gifts and understanding the difference between PETs and Chargeable Lifetime Transfers (CLTs) is key to inheritance tax planning.
• Gifts above the annual exemption of £3,000 will incur inheritance tax so strategic gifting within the limits is key.

Potentially Exempt Transfer for Inheritance Tax Planning

Inheritance tax planning isn’t just about tax minimisation; it’s about maximising the legacy you leave behind. Potentially Exempt Transfers (PETs) are at the heart of this. Understanding how PETs work means you can make informed decisions about gifting assets in your lifetime. PETs are gifts that may be exempt from inheritance tax if the donor survives 7 years after the gift. This can include outright gifts of cash or property, which if the donor survives the 7 years, do not count towards their estate for inheritance tax purposes.

However if the donor dies within 7 years the gift becomes chargeable and will impact the inheritance tax liabilities. Understanding the difference between PETs and Chargeable Lifetime Transfers (CLTs) is key as the latter are immediately chargeable to inheritance tax whereas PETs may be exempt under the right conditions.

Getting these subtleties right is key to effective estate planning and minimising tax on your assets.

Introduction

Timing is everything with PETs. For a transfer to be a PET it must be made by an individual after 18th March 1986. Any gifts made before this date are not PETs and are subject to different tax rules. Timing of gifts and the donor’s survival period are critical factors that can have a big impact on the tax consequences of these transfers.

PETs are a fundamental part of inheritance tax planning because they allow you to reduce the tax on lifetime transfers. Planning the timing and value of gifts can reduce the inheritance tax due on death. This strategic approach means more of your estate goes to your beneficiaries not the taxman.

What is a Potentially Exempt Transfer (PET)?

At its simplest a Potentially Exempt Transfer (PET) is a gift that may be exempt from inheritance tax if the donor survives 7 years after the transfer. These transfers are usually outright gifts, cash or property and are intended not to count towards the donor’s estate for inheritance tax purposes if the survival condition is met. The key condition for a gift to be a PET is that it must be a gift from one individual to another with no strings attached.

The value of PETs is unlimited but the key is the donor must survive 7 years after the gift is made. If the donor doesn’t meet this condition the transfer becomes chargeable and is subject to inheritance tax. Understanding how PETs work and their impact on inheritance tax liabilities is key to effective estate planning.

The difference between PETs and Chargeable Lifetime Transfers (CLTs is big. Both can impact inheritance tax planning but CLTs are immediately chargeable to inheritance tax whereas PETs may be exempt. So PETs are the better option if you want to minimise your inheritance tax liabilities through gifting.

Conditions for a PET

For a gift to be a Potentially Exempt Transfer (PET) it must meet certain conditions. Firstly the transfer must be to another individual or a specified trust. This means the gift must directly increase the recipient’s estate or contribute to its growth. Secondly the gift can be a transfer of value for inheritance tax if it’s a sale for less than market value.

These conditions ensure the transfer is genuinely reducing the donor’s estate and benefiting the recipient. If these conditions are not met the transfer cannot be a PET and may be subject to the relevant property regime and different tax rules.

You need to know these conditions if you’re considering PETs in your inheritance tax planning.

When is a PET Chargeable?

A Potentially Exempt Transfer (PET) becomes chargeable to inheritance tax if the donor dies within 7 years of the gift. So the timing of the donor’s death in relation to the gift is key. If the donor survives 7 years the gift is exempt from inheritance tax and the nil rate band allowances are reset.

But if the donor dies within this period the gift is treated as a chargeable transfer and there could be inheritance tax liabilities. So careful planning and consideration of the donor’s health and life expectancy is crucial when making PETs.

Knowing when a PET is chargeable helps with estate management and minimising tax liabilities.

How to Calculate a PET

The value of a Potentially Exempt Transfer (PET) is the reduction in the transferor’s estate. To calculate this you need to consider the market value of the gift at the time it was made. This ensures the value recorded for inheritance tax purposes is the actual loss to the donor’s estate.

If part of an item is given away the loss to the estate may be more than the value of the gift itself. In these cases the value is calculated by deducting the value of the retained asset from the total value of the combined assets. This way the full impact of the gift on the estate is calculated.

Death Within 7 Years

If the donor dies within 7 years of making a Potentially Exempt Transfer (PET) the gift becomes chargeable to inheritance tax on its value at the time of death. So all gifts made in this period must be included in the inheritance tax calculation. The timing of the gift in relation to the donor’s death is key to the tax liability.

For gifts made between 3 and 7 years before death taper relief applies and the tax rate reduces incrementally with each year. This reduces the tax on gifts made closer to the 7 year mark. But gifts made with a reservation of benefit are included in the donor’s estate and could be double charged to inheritance tax if the donor dies within 7 years.

The tax rate on the taxable amount above the threshold is 40%. So the timing of the donor’s death can have a big impact on the tax liabilities of the estate. Understanding this is key to inheritance tax planning.

PETs in Action

Let’s look at two examples to see how Potentially Exempt Transfers (PETs) work in practice. These examples will show the outcome if the donor survives 7 years or dies within that period.

By looking at these examples we can see how PETs work in practice and the impact on inheritance tax planning.

Example 1: PET and Survival Beyond 7 Years

Amy made a potentially exempt transfer (PET) of £500,000 to her son Peter. To avoid any inheritance tax she must survive 7 years after making the PET. Luckily she does and survives beyond 7 years so the gift is entirely exempt from inheritance tax.

Amy’s previous chargeable lifetime transfer (CLT) doesn’t affect the PET as long as she is alive. The total amount of gifts made by Amy is £825,000. This example shows how surviving 7 years means the lifetime gift is exempt from inheritance tax and benefits both the donor and the recipient.

Example 2: PET and Death Within 7 Years

In this example Amy gifted her son Peter £500,000, her daughter Alicia £500,000 and a gift to a discretionary trust of £325,000. Unfortunately Amy died 5 years and 9 months after gifting £500,000 to Michael which was 1 year after she gifted it to him. Since Amy did not survive 7 years after making a PET the gifts become chargeable to inheritance tax.

The gifts included values of £500,000 to Peter and Alicia and £200,000 to Michael which will be included in the inheritance tax calculation. This example shows the big impact the timing of the donor’s death can have on the tax liabilities of the estate and the importance of planning.

PETs and Chargeable Lifetime Transfers (CLTs

Both Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs) are part of inheritance tax planning and their interaction can have a big impact on tax liabilities. Making a CLT before a PET is a clever move to prevent a failed PET affecting the nil rate band. A failed PET and a CLT made in the 7 years before death are both included in the inheritance tax calculation.

Previous CLTs can reduce the nil rate band available for future gifts and increase potential tax liabilities. If a CLT exceeds the nil rate band in the previous 7 years it will be taxed at 20% lifetime rate.

Understanding the interaction between PETs and CLTs is key to inheritance tax planning and reducing tax.

Annual Exemption and PETs

The annual exemption allows individuals to gift up to £3,000 per tax year without using up the nil rate band. This exemption is applied before any previous gifts when calculating PETs so smaller gifts can be made each year without incurring inheritance tax.

A single gift can be partly exempt and partly chargeable depending on the amount that exceeds the annual exemption. When gifting anything, any part of the gift that exceeds the annual exemption will be chargeable to inheritance tax. Using the annual exemption wisely can help with your gifting strategy.

Trusts and PETs

Special rules apply to Potentially Exempt Transfers (PETs) involving trusts. For example gifts into accumulation and maintenance trusts before a certain date are PETs unless specific conditions apply. Setting up a trust for a disabled person is a PET.

Transfers to a bereaved minor’s trust can be PETs if certain conditions are met. An example of a PET involving a trust is when the settlor is excluded from trust benefits and the trust value at that time is a PET.

You need to know these special rules to include trusts in your estate planning.

Deemed PETs

Deemed PETs occur when a reservation in the gifted property ceases and inheritance tax implications arise. A gift with reservation of benefit is treated as a deemed PET when the donor stops benefiting from the property. These deemed transfers of value imposed by law can be a deemed transfer in certain circumstances such as releasing a life interest.

You need to know about deemed PETs and their consequences to do inheritance tax planning properly as they have a big impact on estate tax.

Reporting and Paying Inheritance Tax on PETs

Reporting and paying inheritance tax on Potentially Exempt Transfers (PETs) involves a number of steps to comply with HMRC rules. The value of the estate including gifts made in the 7 years before death must be reported to HMRC using form IHT500. This must be submitted by 31 January after the end of the tax year the donor died.

The inheritance tax must be paid by the end of the 6th month after the individual’s death. To calculate the value of the estate for inheritance tax purposes the market value of all assets must be assessed and debts subtracted to get the net estate value. This ensures the correct amount of inheritance tax is calculated and paid taking into account any tax relief assets.

Gifts made in the 7 years before death reduce the inheritance tax threshold. An election for inheritance tax on pre owned asset tax cannot be made after the person has died. You need to know these reporting and payment rules to manage your inheritance tax liabilities.

Conclusion

In summary Potentially Exempt Transfers (PETs) are a powerful inheritance tax planning tool, you can gift large parts of your estate without paying tax immediately. By knowing the PET conditions, how to calculate the value and the donor’s death within 7 years you can plan your estate to reduce inheritance tax liabilities. The interaction between PETs and Chargeable Lifetime Transfers (CLTs) shows how important planning and timing is.

Using PETs properly means more of your wealth stays with your loved ones not with the taxman. By including PETs in your estate planning you can benefit from them and navigate inheritance tax with ease.

Frequently Asked Questions

What is a Potentially Exempt Transfer (PET)?

A Potentially Exempt Transfer (PET) is a gift that may be exempt from inheritance tax if the donor survives for seven years after the transfer. This includes gifts of cash or property.

When does a PET become chargeable for inheritance tax?

A PET becomes chargeable for inheritance tax if the donor dies within seven years of making the gift, at which point it is included in the estate for tax calculations.

How is the value of a PET calculated?

The value of a PET is calculated based on the reduction in the transferor’s estate, reflecting the market value of the gift at the time it was made, along with any loss incurred by the estate due to the transfer. This ensures a fair assessment of the gift’s impact on the overall estate.

What happens if a donor dies within seven years of making a PET?

If a donor dies within seven years of making a potentially exempt transfer (PET), the gift is subject to inheritance tax, though taper relief may apply to reduce the tax liability for gifts made between three and seven years prior to death.

How do PETs interact with Chargeable Lifetime Transfers (CLTs)?

PETs can impact inheritance tax liabilities by potentially affecting the nil rate band if a failed PET occurs after making Chargeable Lifetime Transfers (CLTs). Therefore, it is prudent to consider the timing of these transfers to optimize tax implications.