IHT Investigations: Lifetime Gifts, Reservation of Benefit and Trusts

An inheritance tax enquiry arrives when the person who could explain what happened has died and the records were theirs. And the assumption that gets families into most trouble, that seven years solves everything, is simply wrong where a benefit was reserved.

Why IHT Enquiries Are Different

An inheritance tax enquiry usually arrives at the worst possible moment: after a death, when the people who could explain what happened are the ones who have died, and the records were kept by them.

Three features distinguish IHT compliance work from the rest of the tax system:

• The lookback is long. Lifetime transfers within seven years of death come back into charge, and reservation of benefit has no time limit at all.
• Valuation is central. Most disputes are valuation disputes, whether of property, unquoted shares or business assets.
• Personal representatives are personally exposed. They sign the account, and they can be liable for tax and penalties on an incorrect one.

Lifetime Gifts and the Seven-Year Rule

A gift to an individual is normally a potentially exempt transfer, which falls out of account if the donor survives seven years. Gifts into most trusts are chargeable lifetime transfers, immediately chargeable at the lifetime rate above the nil rate band.

Where death occurs within seven years, the transfer comes back into charge, taper relief may reduce the tax, and the nil rate band is applied to earlier transfers first.

What HMRC looks for

• The seven-year question on the account. PRs frequently answer it from limited knowledge. Bank statements for the period are the obvious source and are increasingly requested.
• Regular payments that were treated as normal expenditure out of income. The exemption is valuable and genuinely available, but it requires the gifts to be part of a pattern, made out of income, and to leave the donor able to maintain their usual standard of living. Contemporaneous records are essential and rarely exist.
• Transfers to family members around the time of a care assessment, a diagnosis or a downturn.
• Undervalue sales, which are transfers of value to the extent of the shortfall.

Gifts with Reservation and POAT

This is the single largest source of unexpected IHT charges, and it catches families who thought they had planned.

Where an individual gives away property but continues to enjoy a benefit from it, the property remains in their estate for IHT purposes as a gift with reservation of benefit. There is no seven-year escape.

The classic fact patterns

• Giving the house to the children and continuing to live in it without paying a full market rent. The house remains in the estate.
• Giving a share of the house and continuing to occupy the whole. Whether the reservation rules bite depends on whether the donee also occupies and whether the donor takes a benefit at the donee’s expense.
• Gifting a rental property but continuing to receive the income.
• Trust arrangements under which the settlor retains a benefit.

Where the reservation rules do not apply, the pre-owned assets income tax charge may instead apply to the continued enjoyment of an asset formerly owned, with an election available to bring the property back within the estate for IHT rather than pay the annual charge.

Trusts: the Relevant Property Regime

Most trusts created in lifetime are within the relevant property regime, which charges IHT in three ways:

• Entry charge, on the transfer into trust, at the lifetime rate above the available nil rate band.
• Ten-year anniversary charge: a periodic charge on the value of relevant property, calculated by reference to a rate derived from the nil rate band and the trust’s history.
• Exit charge, when property leaves the trust, calculated by reference to the last ten-year charge or, in the first ten years, to the entry position.

The recurring compliance failures are:

• Ten-year anniversaries simply not diarised, so returns are never filed.
• Related settlements and the settlor’s cumulative transfers not taken into account in the rate calculation.
• Exit charges overlooked on appointments to beneficiaries.
• Trust Registration Service obligations missed, with their own penalties: see our resource on TRS penalties.

Business and Agricultural Property Relief

Business relief and agricultural property relief are the most valuable reliefs in the code and the most heavily scrutinised. The recurring battlegrounds are:

• Wholly or mainly investment. A business consisting wholly or mainly of holding investments does not qualify. Furnished holiday lettings, serviced accommodation, caravan parks and property with services are the perennial disputes, and the level of services provided is decisive.
• Excepted assets: assets not used for the business, notably surplus cash, which are excluded from relief.
• The two-year ownership requirement, and the replacement property rules.
• Binding contracts for sale, which can deny relief.
• Agricultural value versus market value, and whether the occupation and ownership conditions are met.

Our resource on business relief investigations covers the relief in more detail.

Personal Representatives: the Personal Exposure

• PRs sign the account and can be liable for tax and for penalties where it is incorrect.
• The duty is to make proper enquiries before signing: bank statements, the deceased’s papers, questions of family members about lifetime gifts. A PR who signs without enquiring cannot easily argue reasonable care.
• Behaviour matters here too. Under HMRC v Tooth and Auxilium, a deliberate inaccuracy requires knowledge of the error and an intention that HMRC rely on it. A PR who did not know about a gift has not been deliberate, but whether they took reasonable care is a separate question.
• Distribution before clearance is the practical danger. A PR who distributes the estate and then receives an assessment may have no fund from which to pay it.
• Protect the position with proper enquiries, a full disclosure in the account, and consideration of clearance before distributing.

Practitioner Application

1. Obtain seven years of bank statements before completing the account, not after HMRC asks.
2. Ask about the family home directly. Who has lived there, who owns it, and has any rent been paid? This one question surfaces most reservation of benefit problems.
3. Evidence normal expenditure out of income with a schedule showing income, expenditure and the pattern of gifts, prepared from the records rather than from recollection.
4. Diarise trust anniversaries and check the rate calculation against related settlements and the settlor’s cumulative transfers.
5. Get valuations professionally and keep the basis. Valuation is where most IHT disputes are decided.
6. Separate behaviour from valuation in any penalty discussion. A valuation the district valuer disagrees with is not an inaccuracy in the sense the penalty code requires.
7. Consider clearance before distributing, and advise PRs in writing about the risk if they do not.

Frequently Asked Questions