This is the first of a two-part series examining lifetime gifts as part of estate planning. This article considers inheritance tax on lifetime gifts, including potentially exempt transfers (“PETs”), chargeable lifetime transfers (“CLTs”), exemptions, taper relief and gifts with reservation of benefit. It also explains how lifetime gifts can reduce the nil-rate band (“NRB”) available to the estate on death
Part Two considers the implications of lifetime gifts for will drafting, including equalisation between beneficiaries, hotchpot provisions, discretionary trusts, tax allocation and the treatment of lifetime loans.
Lifetime gifting can help family members, pass wealth to the next generation and reduce a future IHT liability. However, understanding inheritance tax on lifetime gifts is essential before implementing any gifting strategy, as gifts do not automatically fall outside the donor’s taxable estate.
Inheritance Tax on Lifetime Gifts: PETs and the Seven-Year Rule
Most outright gifts from one person to another are PETs. A PET carries no immediate IHT charge. If the donor survives for seven years after making the gift, it will fall outside the IHT calculation.
If the donor dies within seven years, the PET becomes chargeable and is brought into account when calculating IHT. Failed PETs are generally considered in chronological order, with the earliest gift using the available NRB first.
Example:
For example, a parent gives £200,000 to a child and dies four years later with a chargeable estate of £500,000.
Assuming no exemptions apply and the full £325,000 NRB is available, the failed PET uses £200,000 of that allowance. Only £125,000 remains available against the death estate.
The estate’s taxable amount is therefore £375,000, potentially producing IHT of £150,000, subject to any other reliefs or allowances.
This shows an important risk: although the gift itself may not produce tax because it falls within the NRB, it can cause the estate to pay considerably more IHT by reducing the allowance available on death
Multiple Gifts and the Order of Taxation
Where a donor makes several gifts, failed PETs are considered in chronological order. This can produce different outcomes for recipients who receive identical amounts.
Example
For example, suppose a person makes:
- a £250,000 gift to Child A six years before death; and
- a £250,000 gift to Child B two years before death.
Ignoring exemptions and any earlier transfers, Child A’s gift uses £250,000 of the £325,000 NRB. Only £75,000 remains for Child B’s gift, leaving £175,000 of that later gift potentially taxable. No NRB would remain for the death estate.
Although each child received the same amount, the later recipient may face a greater IHT liability because the earlier gift had first use of the NRB.
Taper Relief for PETs
Taper relief may reduce the IHT payable on a failed PET where the donor survives for more than three years after making it.
| Time between gift and death | Reduction in tax on the gift | Effective rate |
| Up to 3 years | No reduction | 40% |
| More than 3 but less than 4 years | 20% | 32% |
| 4–5 years | 40% | 24% |
| 5–6 years | 60% | 16% |
| 6–7 years | 80% | 8% |
| 7 years or more | Gift exempt | 0% |
Taper relief reduces the tax payable on the taxable part of a gift. It does not reduce the value of the gift, restore the NRB used by it or reduce the tax payable by the death estate.
Taper relief is relevant only where the combined value of chargeable lifetime transfers exceeds the available NRB. If the gifts fall entirely within the NRB, there is no tax on those gifts for taper relief to reduce.
Taper relief is one of the most misunderstood aspects of inheritance tax on lifetime gifts because it reduces the tax payable on certain gifts but does not restore the NRB used by them.
Example
A donor makes a PET of £425,000 and dies between four and five years later. Assuming no exemptions, reliefs or earlier chargeable transfers, the first £325,000 is covered by the NRB. The remaining £100,000 is initially taxable at 40%, producing IHT of £40,000.
As the donor survived for between four and five years, taper relief reduces the tax by 40%. The resulting IHT on the PET is £24,000.
Who Pays IHT on a Failed PET?
The recipient is generally primarily responsible for the IHT attributable to a failed PET. A recipient may therefore receive and spend a gift, only to face a tax liability several years later. If the gift comprised property rather than cash, the recipient might need to use other resources or sell the asset to pay the tax.
In certain circumstances, including where the tax remains unpaid, liability may also fall on the deceased’s personal representatives.
A will may direct that the estate pays or reimburses tax attributable to a lifetime gift. However, this transfers the economic burden to the beneficiaries of the death estate. Part Two considers this issue in more detail.
Chargeable Lifetime Transfers
CLTs are not a type of PET. They are a separate category of lifetime transfer.
An outright gift to another individual will ordinarily be a PET, whereas a transfer into most relevant-property trusts, including most discretionary lifetime trusts, will ordinarily be a CLT.
A CLT is assessed against the donor’s available NRB when it is made, taking account of chargeable transfers during the preceding seven years.
An immediate lifetime IHT charge arises where the transfer exceeds the available NRB. The lifetime rate is generally 20% where the trustees pay the tax. The effective rate is higher if the donor pays the tax because that payment is itself treated as part of the value transferred.
If the donor dies within seven years of making the CLT, the tax is recalculated using the death rate. Credit is generally given for lifetime tax already paid.
Inheritance Tax on Lifetime Gifts: Exemptions
Some lifetime gifts are exempt from IHT and do not use the NRB.
Annual exemption
An individual may make gifts totalling up to £3,000 in each tax year under the annual exemption. Any unused exemption may be carried forward for one tax year only.
Small-gift exemption
An individual may make gifts of up to £250 to any number of people in a tax year. This exemption cannot be combined with another exemption for the same recipient.
If £300 is given to one person, the first £250 is not exempt under the small-gift rule. The exemption is unavailable for the whole of that gift.
Other exemptions
Other exemptions may apply to:
- gifts between spouses or civil partners;
- qualifying gifts to charities;
- wedding or civil partnership gifts; and
- qualifying normal expenditure out of income.
Gifts with Reservation of Benefit
A gift may remain within the donor’s taxable estate if the donor continues to use or benefit from the asset. This is known as a “gift with reservation of benefit” under the Finance Act 1986.
For example, transferring a house to an adult child while continuing to occupy it rent-free will not remove its value from the donor’s estate. Even if the transfer occurred more than seven years before death, the reservation-of-benefit rules still bring the property into the IHT calculation.
The position may differ where the donor pays a full market rent under a genuine and properly documented arrangement. The rent should be reviewed regularly to ensure that it remains at market level. Separate income tax rules concerning pre-owned assets may also require consideration.
Conclusion
Understanding inheritance tax on lifetime gifts is an important part of will planning. While lifetime gifts can reduce an eventual IHT liability, their tax treatment depends on a range of factors including survival periods, available exemptions, earlier transfers and whether the donor continues to benefit from the asset.
A failed PET may not generate tax on the gift itself but can significantly increase the IHT payable by the death estate by reducing the NRB available on death. Earlier CLTs, multiple gifts and gifts with reservation of benefit can further complicate the position.
Lifetime gifts can also affect how an estate is distributed and whether beneficiaries ultimately receive what the testator intended. Part Two of this series considers how lifetime gifts should be addressed when preparing or reviewing a will.
If you have subscribed to our Quiz Membership 2026, please find this article’s quiz here. You must be signed into the partner area of our website to access this.
This article is provided for general information only and does not constitute legal advice. Any advice, wording or clauses referred to are illustrative and should not be relied upon as precedent without full consideration of the client’s circumstances, the will as a whole, and the law in force at the relevant time.
