When an individual is thinking about making a gift to another individual, consideration needs to be given to the Potentially Exempt Transfer (PET) trap.
Types of gifts
The most common PET is when an individual makes an outright gift to another individual, as opposed to a gift to a trust.
Gifts to any trust, after 22 March 2006, are lifetime chargeable transfers (LCTs). As the name suggests, they are assessable to Inheritance Tax (IHT) at the time they are made, although the nil-rate band (NRB) may be available to ‘cover’ the gift. The lifetime rate of IHT is 20% on LCTs in excess of any available NRB, (half the rate of 40% upon death).
What is the trap?
If an individual has already made an LCT within the preceding seven years, it can result in more IHT being payable if he then makes a PET which he doesn’t go on to survive by 7 years, than if he died with the asset ungifted and assessable to IHT on his death as part of his normal estate. This is due to having to take the earlier LCT into account and deducting it from the now deceased donor’s NRB when calculating if there is any IHT on the failed PET. The LCT is part of the donor’s cumulative total.
An example helps to explain the trap:
What is startling, is that less IHT would be payable if Peter had not gifted the £300,000 to his daughter Ellie in February 2016, and had thus avoided the PET trap:
Avoiding the PET trap
The PET trap means that if a donor has made any LCTs within the preceding seven years, they will be better off tax-wise if they do not then make any PETs that they fail to survive by seven years.
To ‘compensate’ the disappointed donee, a legacy could be left in a Will instead of making the ‘risky’ PET to them. Alternatively, a PET could be made when at least seven years have passed from making the previous LCT. This will prevent a deduction from the NRB when the PET is assessed for IHT, if the donor dies within seven years of the PET.
Of course, the donor could survive the PET by seven years, which also avoids the trap, but there is no way of knowing if this will be the case!
As always, tax isn’t the only consideration however, family dynamics are often the driving force; but any sensible discussion about the timing of PETs being made should include consideration of the PET trap.
For more information about the issues raised in this article, please contact Laura Banks.
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