Inheritance tax shake-up: six ways the 'death tax' could be changing

Inheritance tax could be due a major overhaul, with a new report recommending sweeping changes to gifting rules, life insurance policies and even who pays the bill.

After a request from the Chancellor of the Exchequer, the Office of Tax Simplification (OTS) conducted an extensive review into inheritance tax. Its new reports sets out clear recommendations for reforming the rules, which the government must now respond to.

You won't necessarily have to pay inheritance tax, as the first £325,000 of an estate is tax-free. And if your home passes to your child or grandchild, the estate can be worth up to £475,000 in 2019-20 before tax is payable.

Indeed, last year just 24,500 estates were landed with a tax bill, accounting for around 4% of all deaths in the UK. Yet while the number of people affected is small, the bills can be enormous, with a tax charge of 40%.

Whether you're planning your legacy, or dealing with an inheritance, it's vital to know how the rules work. We explain what recommendations the OTS has made and how they would affect inheritance in the UK.

1. Shortening the time limit for taxable gifts

You may be tempted to give away your money while still alive, so you can watch your relatives enjoy their inheritance.

But currently, if you die within seven years of giving the gift, the person who received it may still have to pay inheritance tax in some circumstances.

The Office of Tax Simplification has proposed shortening this period to five years so that only more recent gifts are taxable.

However, it's not all good news. At the moment, the rate of tax you pay goes down based on how many years ago the gift was given - known as taper relief.

The OTS suggests abolishing this taper so that everyone pays the same rate. While less complex, this means people who were given gifts five years ago or less would end up paying a much bigger bill.

• Find out more: Inheritance tax-planning and tax-free gifts

2. Changing who pays inheritance tax on gifts

Most people won't have to pay tax on a gift, even if it was made within seven years of the giver's death. This is because the inheritance tax-free allowance (technically known as the 'nil-rate band') is allocated to gifts first.

So, unless the deceased was quite generous, most gifts should be covered under the £325,000 (or £475,000 including property) threshold.

However, if the total value of the gifts is higher, inheritance tax will kick in. And the recipient is the one to pay it.

The OTS has said many people found this 'counter-intuitive', and spent their gifts without considering possible future tax implications.

It recommends that the estate should be liable for paying inheritance tax on gifts, so that recipients aren't caught out unexpectedly. It also recommends allocating the nil-rate band across all gifts proportionally, rather than chronologically from oldest to most recent.

3. Reforming IHT exemptions to gifts

Even if your estate is worth more than the nil-rate band, there are circumstances where you can give away gifts without them counting as part of your estate.

You can give away up to £3,000 per year exempt from your estate, plus you can give up to £5,000 to your child when they get married. In addition, you can make small gifts of less than £250, as long as it's to different people, and give regular gifts out of your normal income.

These rules can be confusing, so much so that many people don't have have a good understanding of which gifts will be exempt, the OTS found.

Instead, the OTS recommends replacing the annual £3,000 limit and the marriage gift rules with a single allowance, known as the 'personal gift allowance.' While it doesn't suggest a figure, it notes that limits have been frozen since the 1980s, despite rising price inflation.

In addition, it suggests changing the rules around 'regular gifts from income'. Under its proposals, gifts wouldn't need to be regular, though there would be a limit on how much you could give away.

4. Exempt all life insurance policies from inheritance tax

Currently, any payments from a term life insurance policy are only exempt from inheritance tax if the policy is written into a trust - which many aren't, the OTS found.

Inconsistent practices within the financial services industry mean many policies are sold without a trust, even though there are clear benefits to forming one.

To avoid this confusion, all death benefit payments from term life insurance should be exempt, the OTS suggested, regardless of whether the policy is written in trust or not.

• Find out more: how to write life insurance into trust

5. Remove the capital gains tax uplift

Generally, if you inherit an asset, you can sell it shortly afterward without needing to pay capital gains tax.

This is because HMRC looks at the asset's market value when you receive it, rather than the price the deceased originally paid for it.

Where there's also an exemption for inheritance tax, this may mean that you wouldn't pay any tax at all. The OTS has recommended changing the capital gains rules, so that the asset is valued at its original price where a relief or exemption from inheritance tax has been applied.

This may mean you'll need to pay capital gains tax to sell it - however, it will simplify the system and encourage people to make transfers during their lifetime, the OTS said.

6. Review treatment of businesses and farms

There are a number of exemptions designed to allow businesses and farms to be passed on without being broken up or sold, including business property relief and agricultural property relief.

The OTS recommended a number of changes to the current rules, including:

• considering whether the level of trading activity required to qualify for business property relief should continue to be lower than that for other business tax reliefs
• reviewing how indirect non-controlling holdings in trading companies are treated
• considering whether to align inheritance tax rules on furnished holiday lets for with rules for income tax or capital gains tax
• reviewing the treatment of limited liability partnerships
• reconsidering the approach to agricultural property relief when a farmer needs to leave their farmhouse for care or medical treatment.

When will these inheritance tax reforms be implemented?

The OTS report only contains a list of recommendations, so the current rules haven't changed.

You can find out more about how the rules work in our guide to inheritance tax.

As a next step, the government will consider the OTS' recommendations and issue a response.

Large-scale tax changes are often announced in the Autumn Budget, traditionally held in November. However, this may come earlier - or potentially be pushed back - after a new Prime Minister is selected later this month.

• Find out more:how to cut your inheritance tax bill