The option of “gifts out of income” is becoming more visible as families in the UK consider the impact of inheritance tax. This article considers the details.
In the following article, the
author – Liz Cuthbertson ([pictured below), partner
at chartered accountants firm Mercer & Hole –
talks about the rules applying to gifting wealth from surplus
income and how they fit with UK inheritance tax (IHT). In light
of
the Autumn Budget and the freeze of IHT thresholds, and
concerns there have been about exemptions, this is a timely
article. We have recently noted the rising
tax take from IHT.
The editors are pleased to share these insights; the usual
editorial disclaimers apply to views of guest writers. Please
comment if you have views. Email tom.burroughes@wealthbriefing.com
and amanda.cheesley@clearviewpublishing.com
Liz Cuthbertson
Iheritance tax has been hitting the headlines recently, with
questions raised over changes the government may implement soon.
As more families find themselves unexpectedly caught in the
inheritance tax net, there is growing interest in legitimate
strategies to mitigate liability and pass on wealth
tax-efficiently. One simple way to pass some wealth to another
individual is by way of exempt “gifts out of income.”
There is no monetary limit to giving a gift out of your surplus
income, provided the qualifying conditions are met. It is a
personal decision whether to make a gift, and there are many
other considerations. But one of the benefits of them is that
they can be personalised. Gifts out of income can be a way to
assist with grandchildren’s education costs, for example, rather
than being made directly to an individual.
Giving wealth away is often one of the easiest ways to reduce the
inheritance tax burden. However, in advance of doing so, the
affordability of the donor to make gifts should always be very
carefully considered, and gifts made should be unconditional,
with no benefit derived thereafter by the donor.
What if the rules for exempt giving
change?
Whilst there is always the risk of tax changes ahead, when it
comes to effective succession planning and
transferring wealth from one generation to another,
reviewing your affairs and understanding long-term goals and
objectives is the most important step. As the rate of inheritance
tax is 40 per cent on death, the absence of careful planning can
risk significant erosion of family wealth.
Exempt – or potentially exempt?
Gifts for inheritance tax purposes fall into two categories –
exempt gifts and potentially exempt gifts.
Exempt gifts reduce the donor’s estate immediately. Potentially
exempt gifts reduce the donor’s estate in full after seven years
have lapsed from the date on which the gift was made. Exempt
giving can therefore be extremely valuable and, over time, can
significantly reduce the IHT charge in a person’s estate whilst
also enabling wealth to pass to others in a tax-efficient way.
What counts as a “gift out of income”?
There are some specific small exempt gifts, but the most valuable
exempt gift is one made out of a person’s surplus income. This is
because there is no financial limit on the amount of a gift under
this heading, provided all the qualifying conditions are met.
A gift out of surplus income will be exempt from inheritance tax
if all the following conditions are met:
1. The gift is made from your surplus income;
2. The gifts are part of the donor’s “normal expenditure”; and
3. The donor is left with enough income to maintain their normal
standard of living.
We start by identifying a person’s total income, which includes
all income, including non-taxable income such as ISA
interest. Therefore, it includes dividends, pensions, rental and
other income.
Looking ahead to a time when the pension pot may be included in a
person’s estate (currently proposed from 6 April 2027), subject
to analysis, an individual could bolster their income by drawing
income from their pension. The pension drawn would form part of
the individual’s total taxable income but could be a means to
increase or even generate surplus income to enable further exempt
gifts.
What is surplus income?
An individual’s surplus income is their income that is left over
after all their regular outgoings and expenses have been paid,
which includes tax and bills. The starting point is generally the
net of tax income for the year, with all normal expenditure then
deducted. If, after accounting for all normal expenditure, there
is surplus income, then it is usually possible to make exempt
gifts out of it.
It is important that the individual can demonstrate that all
their normal expenditure was met out of their income. If you give
away your income and fund your own life by spending your capital,
the gifts will not qualify. Further conditions also apply.
What is normal expenditure?
The question of what constitutes ‘normal expenditure’ is not
defined in statute, but HMRC adopts the dictionary definition of
‘normal’, which is “standard, regular, typical, habitual or
usual”. Normal means normal for the donor or transferor i.e. the
person making the gift.
All relevant factors must be considered i.e. frequency and number
of gifts, the nature of the gifts, the identity of the
recipients, and the reasons for the gifts.
What constitutes a “pattern of giving”?
HMRC guidance says it is usually clear whether or not there is a
pattern of giving, but it is not always that simple. It is
possible that a number of gifts by one person may not qualify. It
is also possible for a single gift to qualify if it is – or is
intended to be – the first of a pattern and there is evidence of
this.
There is no set timespan required to establish a pattern of
giving, although HMRC have previously suggested three to four
years. There is also no fixed minimum period
for establishing the relief; however, it generally needs to
be more than one payment. In the event that only a single payment
had been made and the donor unexpectedly died, it would generally
be necessary to demonstrate that the single payment was intended
to be the first of a pattern of further giving.
Due to inevitable subjectivity and uncertainty which could
result, documentation of evidence, intentions, and facts is very
important.
Are there any time limits to making the
gifts?
HMRC generally takes the view that income becomes accumulated to
capital after three years. A gift out of capital does not qualify
as an exempt gift. So, it is important to ensure that gifts are
made within the time frame in which it can be easily demonstrated
that they are out of surplus income and therefore in advance of
reinvestment into capital.
We generally review the position annually to capture and optimise
the use of the relief where clients have scope and wish to do so.
How important is record keeping?
It is essential to keep records of your income and expenditure,
in case HMRC raises a future enquiry or compliance check by which
time the donor is deceased, and the evidence is entirely
dependent on the quality of recordkeeping. We keep summaries of a
client’s annual income and expenditure on HMRC form IHT 403 in
preparation for this time.
At the very least, we would recommend that the donor should:
— Write a letter to each person to whom you would like to
make gifts, in which you make your intentions clear;
— Ensure that your financial records are up to date with
income and expenditure analysis for each financial year that can
demonstrate that the gifts do not impact your standard of living;
and
— Make regular gifts at specific times of the year (i.e. at
Christmas, or on birthdays), or at certain points, for example,
when a child or grandchild goes to university.
A gift for a specific special purpose does not generally qualify
for example, a gift to help a child buy their first property.
Can gifts out of income be made to a trust?
Gifts out of surplus income can also be used to add to an
existing trust or to a new trust and can therefore be an
efficient way to bolster the value of wealth protected within a
trust. In the absence of qualifying reliefs, the maximum value
that an individual can transfer to a trust without incurring an
immediate charge to IHT is a sum equal to the nil rate band of
£325,000 ($437,509).
A gift to a trust is not an exempt gift unless it is made out of
the donor’s surplus income and meets all the other conditions.
Provided it does, the donor can make the gift to a trust which
could be for the grandchildren, for example. Over time, the value
of the gifts adds up and can result in significant reduction in
inheritance tax and protection of a ring-fenced sum for a
generation ahead.
Transfers to trusts in lifetime are reported to HMRC on the
relevant forms, and we will assist with all associated compliance
matters.
To sum up, making gifts out of surplus income can be a valuable
relief which adds up over time. The necessary conditions must be
met, and documentation is vital. However, it is a relatively
simply and flexible way to give some wealth away in lifetime and
obtain immediate relief for that. Early consideration of it is
best to optimise its value but also ensure that it works in
tandem with wider family objectives and planning.
If you are unable to make any exempt gifts out of your income,
there are many other possibilities to consider, and the starting
point is to review your overall balance sheet and objectives to
establish an appropriate range of options that work for you and
your family.