inheritance tax

inheritance tax, assessment made on the portion of an estate received by an individual; it differs from an estate tax, which is a tax levied on an entire estate before it is distributed to individuals. The inheritance tax is usually progressive and is determined by the amount of property received by the beneficiary, as well as by his or her relationship to the deceased. Strictly speaking, it is a tax on the right to receive the property; the estate tax can be characterized as a tax on the right to transmit the property. All states impose either an estate tax or an inheritance tax, some states employing both. A related federal levy is the gift tax, designed to prevent people from avoiding inheritance and estate taxes by giving away property before death.

In the United States, the federal government levied inheritance taxes during the Civil War period and again during the Spanish-American War; since 1916, however, a progressive estate tax has been imposed. The U.S. tax law of 1981 greatly reduced estate and gift taxes by raising exemptions (from $175,000 to $600,000) and lowering rates, and a 2001 law calls phase out the federal estate tax by 2012; estate taxes in 40 states that are based on the federal tax credit for state estate taxes would be phased out in 2006.

Levy on the property accruing to each beneficiary of the estate of a deceased person. Inheritance tax may be more difficult to administer than estate tax because the value passing to each beneficiary must be fixed, and this often requires complex actuarial calculations. Inheritance taxes date back to the Roman Empire. In the U.S. inheritance taxes have always been collected by the individual states, while the federal government has imposed an estate tax. The first state inheritance tax was imposed by Pennsylvania in 1826.

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In the United Kingdom, Inheritance Tax was first introduced as a tax on estates in England and Wales over a certain value from 1796, then called legacy, succession and estate duties. The value changed over time and the scope of estate duty was extended. By 1857 estates worth over £20 were taxable but duty was rarely collected on estates valued under £1500. Death duties were introduced in 1894, and for the next century were effective in breaking up large estates.

Currently, 94% of all estates escape Inheritance Tax, mainly because they fall in the nil rate band.

Inheritance tax

Estate duty was replaced in 1975 by Capital Transfer Tax, which was rebranded Inheritance Tax (IHT) in 1986. Partly due to the simple and widely-used methods which are available to avoid it, Inheritance Tax accounts for about 0.8% of government income, raising around £2 billion in 2001 and £3.6 billion in 2006.

For the 2008/2009 tax year, the IHT rate is 0% on the first £312,000 (the "nil-rate band), and 40% on the rest of the value, at death, of an individual's tax estate. The nil rate band rises annually; tax is only payable on the value of an estate above the nil rate band. For example, all other things being equal, an individual whose estate is £354,000 (the mean London house price in 2007) will pay IHT amounting to 0% of £312,000 plus 40% of £42,000 i.e £16,800 in all. This is 40% of the amount over the nil rate band, but in this example, 4.7% of the total value of the estate. Those whose estates match the average nation-wide house price of £210,000 will pay zero IHT.

In the 2007 budget report the Chancellor of the Exchequer announced that the nil rate band is to rise to £350,000 by 2010. This is said to take into account the sharp rise in house prices in the United Kingdom over the past few years., although in fact it represents an increase below the rate of house price inflation.

Tax estate

The tax estate includes:

1. all of the deceased's assets, whether real estate or personal estate, and includes even small-value items such as the contents of his or her home;
2. any gifts made by the deceased in the seven years before death;
3. some assets which were not owned by the deceased but which are affected by the death (the most common example is a life interest in a trust, technically known as an interest-in-possession);
4. gifts with reservation of benefit. These are gifts where the legal ownership passes to the recipient. However, the donor continues to enjoy the benefit of the asset either rent free or at reduced cost. The seven year period outlined above does not begin counting down whilst a gift is considered to be under a reservation of benefit.

There is also a charge on "lifetime chargeable transfers" into certain trusts (and a recalculation of those charges if the giver dies within seven years), and trusts themselves have an inheritance tax regime. See Taxation of trusts (United Kingdom).

Deductions

There are deductions for:

1. all assets left to a UK-registered charity.
2. some political donations to major political parties.
3. gifts of up to £3,000 in total in a given year.
4. "small gifts" of up to £250 made to separate individuals.
5. some business assets (under Business Property Relief or "BPR").
6. some farmland (under Agricultural Property Relief or "APR").
7. gifts made out of income that do not affect the standard of living of the donor.
8. gifts made in contemplation of a marriage or civil partnership. The allowance ranges from £5,000 to £1,000 according to the closeness of the relationship of the donor to the person marrying or entering into a civil partnership.

Minimising IHT

In order to avoid IHT, many people in the IHT bracket practise some or all of the following avoidance measures:

• Outright gifts to another individual made during a person's lifetime are known as "potentially exempt transfers" or PETs. They are taxable if the person dies within seven years, but have the potential to become exempt from tax once the donor survives seven years. There is no reduction in inheritance tax if the donor dies within three years of the transfer. However if the donor survives three years, the rate of tax on the PET reduces by one fifth (to 32%) and then by a further fifth on each of the subsequent anniversaries (to 24%, 16% and then 8%) until the PET is fully exempt from inheritance tax after seven years. This is known as inheritance tax taper relief (not to be confused with the better-known capital gains tax taper relief).
• Gifting assets to a trust fund before death. (Some gifts of this kind, however, are disadvantageous as they amount to lifetime chargeable transfers on which half the IHT is due immediately if the cumulative total of chargeable gains gifted exceeds the nil-rate band (£300,000 in 2007/08). This applies to many more trusts, including discretionary/flexible trusts, than previously under legislation introduced by the 2006 budget. See Taxation of trusts (United Kingdom).)
• Certain special types of trust, such as Discounted Gift Trusts and Gift & Loan Trusts, which allow for some planning whilst retaining some access to capital/income.
• Charitable giving, which is IHT exempt.
• Lifetime gifts within certain limits are completely exempt. These include any number of "small gifts" (up to £250 per recipient per year), an annual amount of £3,000, all regular gifts from surplus income, and some wedding gifts.
• Upon death, passing non-taxable assets to the next generation (or to a discretionary trust for the benefit of the whole family) and therefore NOT to the spouse. This may seem counter-intuitive because gifts to a spouse are IHT exempt and should therefore be maximised. However, if something is non-taxable on the first death it should not go to the spouse as it will merely increase their tax estate upon their later death. (The nil-band discretionary trust, discussed below, is an example of this principle in action.) Following changes in the 2008 budget (see below) this strategy may not be necessary.

Inheritance tax allowances became transferable October 2007

The Chancellor's Autumn Statement on 9 October 2007 announced that with immediate effect inheritance tax allowances (often referred to as the nil-rate band) were to be transferable between married couples and between civil partners. Thus, for the 2007/8 tax year, a married couple will in effect have an allowance of £600,000 against inheritance tax, whilst a single person's allowance remains at £300,000. The mechanism for this enhanced allowance is that on the death of the second spouse to die, the nil rate band for the second spouse is increased by the percentage of the nil rate band which was not used on the death of the first spouse to die.

For example, if in 2007/08 the first married spouse (or civil partner) to die were to leave £120,000 to their children and the rest of their estate to their spouse there would be no inheritance tax due at that time, and £180,000 or 60% of the nil rate band would be unused. Later, upon the second death the nil-rate band would be 160% of the allowance for a single person, so that if the surviving spouse also died in 2007/08 the first £480,000 (160% of £300,000) of the surviving spouse's estate would be exempt from inheritance tax. If the surviving spouse died in a later year when the nil rate band had reached £350,000, the first £560,000 (160% of £350,000) of the estate would be tax exempt.

This measure was also extended to existing widows, widowers and bereaved civil partners at 9 October 2007. So if their late spouse or partner had not used all of their inheritance tax allowance at the time of their death, then the unused percentage of that allowance can now be added to the single person's allowance when the surviving spouse or partner dies. This applies however long ago the first spouse died, but there are special rules if the surviving spouse remarried.

In a judgement following an unsuccessful appeal to a 2006 decision by the European Court of Human Rights, it was held that the above does not apply to siblings living together. The crucial factor in such cases was determined to be the existence of a public undertaking, carrying with it a body of rights and obligations of a contractual nature, rather than the length or supportive nature of the relationship.

Prior to this legislative change, the most common means of ensuring that both nil rate bands were used was called a nil band discretionary trust (now more properly known as NRB Relevant Property Trust*). This is an arrangement in both wills which says that whoever is the first to die leaves their nil band to a discretionary trust for the family, and not to the survivor. The survivor can still benefit from those assets if needed, but they are not part of that survivor's estate.

• Finance Act 2006

Pre-owned assets

The Finance Act 2004 introduced a retrospective income tax regime known as pre-owned asset tax (POAT) which aims to reduce the use of common methods of IHT avoidance.

Criticism

In August 2006, former Cabinet minister Stephen Byers called for IHT to be abolished in an article in the Sunday Telegraph..

On 16 October 2006, Philip Johnston, writing in The Daily Telegraph had a scathing leading article against inheritance taxes and called for David Cameron, new leader of the Conservative Party (UK), to announce the demise of a catch-all inheritance tax as a main plank in that party's next manifesto. .

Despite the, perhaps understandable, criticisms of taxes that occur when someone dies, it is accepted by many that it makes sense to tax people that can no longer use their money. In addition, it can have redistributive qualities, taking money away from those that can afford it and redistribute it. For example, The Economist published an article in October 2007 which highlights this, but also acknowledges the political controversy it can cause, and suggests some ways to reform it.

References

See also

• Asset-based egalitarianism
• Disclaimer of interest (including Deed of Variation)
• History of the English fiscal system

External links

• Revenue and Customs Inheritance Tax
• List of UK Regional Probate Registries - Regional Offices for probate information and to register the location of a Will and/or Executor
• The National Will Database - a UK register of Wills and Executors, trying to reduce the number of lost Wills in the UK