How does the inheritance tax 14-year rule work?

Q. I have heard that the seven-year rule for inheritance tax (IHT) can sometimes become a 14-year rule. Please could you explain how that works and when it would apply?

A. This is a tricky and often overlooked area of estate planning. You are correct that, in some circumstances, His Majesty’s Revenue & Customs (HMRC) can look back up to 14 years, rather than the usual seven, when calculating an IHT liability.

But, first, a quick recap of the seven-year rule.

If you make an outright gift to another person – for example, giving £20,000 to an adult child – it will normally be a potentially exempt transfer, or PET. There is no IHT to pay when the gift is made. If you survive for seven years, it generally falls outside your estate for IHT purposes. If you die within seven years, however, the gift can become “chargeable” i.e. it must be taken into account when working out the IHT bill.

The complication comes when a gift into certain types of trust is made before the gift to an individual.

• Read: This IHT mistake could cost you £78,000

Many lifetime gifts into trust – a discretionary trust is the classic example – are treated differently. Instead of being PETs, they are chargeable lifetime transfers, or CLTs.

A CLT is assessed for IHT when it is made. If the transfer, together with any other chargeable transfers made in the previous seven years, falls within the donor’s available £325,000 nil-rate band, there will generally be no immediate IHT to pay. However, the transfer isn’t simply forgotten. It can still use up some or all of the nil-rate band when later gifts are assessed.

If somebody:

1. puts money into a discretionary trust (a CLT)
2. then gives money directly to an individual (a PET) and
3. dies almost seven years after that second gift

Then HMRC can look back up to 14 years when calculating the tax due.

Because they died within seven years of the gift to the child, that PET "fails" and becomes chargeable. To calculate the tax on it, HMRC has to look back a further seven years from the date of the PET to establish whether earlier CLTs had already used any of the donor's nil-rate band.

That means a gift into trust made nearly 14 years before death can potentially affect the IHT calculation.

• Read: When the IHT 7-year rule becomes a 14-year rule

It’s worth stressing that HMRC isn’t simply imposing a new 14-year survival period on every gift. The ordinary rule for gifts made directly to individuals remains seven years.

The effective 14-year period comes about because two seven-year look-back periods can overlap: first, seven years back from death to a failed PET, and then a further seven years back from that PET to any earlier chargeable transfers.

The type of trust involved is important. "Trust" is a broad term and the IHT treatment isn’t identical in every case.

A bare trust is the simplest form. With bare trusts, the beneficiary has the right to all the capital and income of the trust at any time if they’re 18 or over (in England and Wales), or 16 or over (in Scotland). A genuine gift into a bare trust will generally be treated for IHT purposes much like an outright gift to that beneficiary, so it will normally be a PET rather than the sort of CLT that causes the 14-year problem.

A discretionary trust is different. The beneficiaries don’t have an automatic right to a particular share of the money. Instead, the trustees have discretion over who receives money, when and how much. A lifetime transfer into a typical discretionary trust will normally be a CLT. This is therefore the type of trust most obviously associated with the 14-year rule.

Therefore, the key question for the 14-year rule isn’t just, "Was there a trust?". It’s: "Was the earlier gift a chargeable lifetime transfer?". The answer can depend on the structure of the trust, so this is an area where taking professional advice before making the gift is particularly important. Read more on how trusts can be used in estate planning here.

The best way to illustrate the impact is using an example. Consider the hypothetical example of Tim.

Tim is divorced and eventually dies with an estate worth £1.8 million.

June, Year 1: Tim puts £325,000 into a discretionary trust for his grandchildren. This is a CLT. Because the transfer is within his £325,000 nil-rate band, assuming he has made no other relevant transfers, there is no immediate IHT bill.

May, Year 8: Seven years later, Tim gives £325,000 directly to his daughter to help her buy a larger home. This is a PET.

April, Year 10: Tim dies, two years after making the gift to his daughter.

At first glance, you might assume the trust no longer matters. Tim made that gift nine years before his death, comfortably outside the usual seven-year window.

But Tim died only two years after giving £325,000 to his daughter. The PET therefore fails and becomes chargeable.

When HMRC works out how much nil-rate band is available to set against that failed PET, it looks at CLTs in the seven years before the PET was made. The £325,000 discretionary-trust gift falls into that period.

That earlier CLT has therefore used Tim's entire £325,000 nil-rate band.

Without the trust gift, the £325,000 PET to his daughter would have been completely covered by his nil-rate band. There would be no IHT on the gift itself. His £1.8 million estate would then be taxed at 40% in this simplified example, producing an IHT bill of £720,000.

Once the earlier trust gift is taken into account, there is no nil-rate band left to shelter the £325,000 PET.

Because Tim dies within three years of making the gift to his daughter, there is no taper relief (for more on taper relief, watch our YouTube video on ‘What people get wrong about the seven-year rule’). The entire £325,000 is therefore taxed at 40%:

£325,000 × 40% = £130,000.

The estate still bears £720,000 of IHT in this simplified example, taking the family's overall bill to £850,000.

Therefore, the earlier trust planning has increased the IHT bill by £130,000.

If you want to avoid being caught out by the so-called “14-year rule”, the first line of defence is good record-keeping. Anyone making substantial gifts should keep a clear record of what was given, to whom, on what date, and whether a trust was involved. A gift that is more than seven years old shouldn’t automatically be forgotten if later gifts have been made.

• Read: How to keep IHT records and avoid an unnecessary bill

Second, understand whether a gift is a PET or a CLT before making it. An outright gift to an individual and a transfer to a discretionary trust may achieve similar family objectives, but they can have very different IHT consequences.

Third, advisers will sometimes consider leaving at least seven years and a day between a significant CLT and a subsequent PET. The reason is that, if the later PET subsequently fails, the earlier CLT should then fall outside the seven-year period used to establish the nil-rate band available to that PET.

That doesn’t mean people should automatically avoid trusts. Trusts can be extremely useful where the donor wants more control over how and when assets reach beneficiaries. The important point is that the tax implications need to be considered too.

It is also worth making use of the IHT exemptions that are available. These include the £3,000 annual gift exemption, the small gift and wedding exemptions, and potentially the normal expenditure out of income exemption for regular gifts that meet the conditions. Gifts qualifying for an exemption don’t have to wait seven years to fall outside the estate.

• Read: IHT gifting allowances: 8 key questions answered

Tax rules can change and the taxation of trusts is extremely complicated, so people considering large gifts or establishing a trust should get appropriate tax, legal or financial advice.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of our Fidelity’s advisers or an authorised financial adviser of your choice.