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Although only accounting for less than 0.7% of the total UK tax take, inheritance tax is one of the most talked about, and most disliked taxes in the UK. Many people feel aggrieved to have been charged income tax during their lifetime, only to suffer a huge hit on anything they have managed to save up when they die. Of course, this sense of injustice relies upon the notion that taxes are supposed to be fair

The basics

Inheritance tax is levied against the deceased's Estate- the sum of his assets liable to UK inheritance tax, less allowable liabilities. Tax is calculated at a flat rate of 40% to the extent the value of the Estate exceeds the available nil rate band. The nil rate band amount is currently £325,000 per person, but will be reduced by the value of chargeable gifts made in the seven years prior to death.

Lifetime giving

Inheritance tax also applies to most gifts made during lifetime. However, most gifts to other individuals are Potentially Exempt Transfers (PETs), which means that any inheritance tax due only becomes chargeable if the donor fails to survive seven years. Certain gifts to trusts used to also be considered PETs, such as those to interest-in-possession and accumulation and maintenance trusts. However, the changes to trust rules in 2006 mean that most gifts into trust are now considered Chargeable Lifetime Transfers, and are chargeable to inheritance tax immediately, to the extent they exceed any available nil rate band.

The value of a lifetime gift is calculated with reference to the diminution in value of the donor's Estate. In the simple example of a cash gift, the diminution in value will equal the sum gifted. However, in the case of shares, particularly unquoted shares, if the gift causes the donor's holding to drop from a majority to a minority holding, the value gifted may far exceed the nominal share price.

The rate of tax on chargeable lifetime gifts is 20%, although a tapering relief applies where the donor has survived more than three, but less than seven years from the date of gift. The nil rate band is applied first to any lifetime gifts, so it is possible to make chargeable gifts of up to £325,000 every seven years without incurring a charge to tax. However, as mentioned above, lifetime gifts will use up any nil rate band that would otherwise be applied to a death Estate.

Spouses

Importantly, gifts between spouses or civil partners are exempt from a charge to inheritance tax, whether in lifetime or on death, enabling men to keep their wives in expensive shoes. Unfortunately for such shoe-funding men, there is no limit on the amount that can be given to a spouse, with the exception of non-UK domiciled spouses, where there is a limit of £55,000.

In practice, this exemption can be very useful on death, as if an entire Estate is left to the surviving spouse, no inheritance tax is due on that first death. However, when the second spouse dies, he or she has no surviving spouse (assuming they haven't jumped into bed with the next Johnny-come-lately) so the combined sum will be chargeable to tax. Worse still, until recently, the surviving spouse would only have their own nil rate band available, which could have given rise to an unnecessary tax charge.

With effect from 9 October 2007, any surviving widow or widower is now able to benefit from a transferable nil rate band equal to the proportion of the deceased spouse's unused nil rate band on death. In many cases this will prevent an unnecessary charge to inheritance tax, but this may not be the case in situations of remarriage. Particularly where large Estates are concerned, it may be more prudent to use trusts to protect assets on first death rather than relying on the nil rate band extension.

The bottom line

In summary, the best way to avoid inheritance tax is to give all your assets away to your favourite people (who may or may not be your relatives) at least seven years before you die. Of course, not knowing when you are due to pop your clogs can make this type of tax planning a little difficult.

Still, you'd best make sure you get it right because if you continue to derive any benefit from assets you have given away, like giving your house to your children but still living in it, the taxman will get that too