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Lifetime Tax Planning – Valuable Inheritance Tax Exemptions

 “…in this world nothing can be said to be certain, except death and taxes”. However, with careful lifetime tax planning, it is possible to reduce your potential inheritance tax (“IHT”) bill payable on death.

This note is not an exhaustive list of the life time tax planning tools available. Instead, it focuses on:

  • The exemption from IHT for normal expenditure out of income (“the Income Exemption”); and
  • The exemption from IHT for wedding gifts (“the Wedding Gift Exemption”).

The Income Exemption

The Income Exemption is a valuable exemption which allows individuals to gift an unlimited amount during their lifetime which, provided the gift does not exceed the transferor’s surplus income, is immediately exempt from IHT.

This differs from a potentially exempt lifetime transfer (“PET”) as there is no need for the transferor to survive the gift by 7 years to gain the full benefit of the exemption. Furthermore, exempt gifts out of income do not eat into the transferor’s Nil Rate Band (“NRB”) leaving it fully intact so their NRB can be applied in its entirety against the transferor’s estate on death.

Qualifying Conditions

To receive the benefit of the Income Exemption, it important that the following qualifying conditions are met:

  1. The gift must be made out of income

For the Income Exemption to apply, gifts must be made out of net income after tax. By way of example, income could include salary, commissions or rent received, dividend income from shares or interest paid on a bank account.

Gifts from income usually take the form of a monetary gift. However, HMRC will accept that a gift of another asset can qualify for the exemption provided that the asset was purchased specifically from the surplus income with the intention of making a gift.

Gifts made from capital (including capital content of a purchased life annuity or capital sums from the sales of investment) are not covered by the Income Exemption.

  1. The gift must be made out of surplus income

After making a gift out of income, the transferor must be left with enough income to maintain his usual standards of living for the Income Exemption to apply.

The Income Exemption will not usually apply if the transferor needs to resort to spending capital to meet their accustomed cost of living after gifts have been made out of income. The assessment of need and accustomed cost of living is fact specific and considers the transferors own standard of living, rather than the stand of living of the “average” person.

By way of example, after repaying their mortgage, grandparents could make comparable monthly payments to their grandchildren instead of mortgage payments. Payments to their grandchildren would not reduce the grandparents’ standard of living as their disposable income would remain the same.

  1. The gift must be part of “normal” expenditure

What is “normal” for the purpose of the Income Exemption is not defined. However, it must be established that a gift out of income forms part of a settled pattern of gifting. The Income Exemption will rarely apply to one off gifts.

Ideally, there should be evidence of an intention to make regular gifts over a period of time. This will also protect the exempt status of the first gift in a series of gifts if it is evidentially clear that further gifts are intended. 

HMRC guidance suggests that a reasonable time frame for establishing a pattern of gifting would normally be three to four years. HMRC does not a set period for regularity of gifts. Gifts could be monthly, quarterly or even every other year. The important thing is that an established pattern of gifting can be demonstrated.

A pattern of gifting must be established by proving a prior intention to make regular gifts, or evidence to show that there was a pattern e.g. a standing order to pay grandchildren’s school fees. Gifts do not need to be made to the same person, or be for the same amount.

Practical Points

  • The Income Exemption is very flexible. Even though you need to establish a pattern of gifting, if your circumstances change, you can discontinue, reduce or even increase your gifts out of income. Past gifts that meet the qualifying conditions for the exemption will remain exempt despite a change in circumstances that may prevent you from making future gifts.
  • The Income Exemption is not automatic. Your executors claim the Income Exemption retrospectively after your death by completing form IHT403 to prove that the qualifying conditions were met. Form IHT403 requires your executors to break down your income, living expenses and gifts by year for the 7 years prior to your death (any gifts over 7 years before your death will automatically be treated as exempt).If you intend to make gifts out of income, it would be advisable to keep clear cash flow records detailing your available income year on year. It may also be worth preparing letters to beneficiaries that set out your intention to make regular gifts from surplus income.
  • As the Income Exemption is retrospective, and HMRC is entitled to raise queries in relation to gifts out of income, it is important to take advice at the time of making gifts out of income to make sure the qualifying conditions are met. This will ensure your executors are in the best position when making the claim for the exemption following your death.
  • The Income Exemption can be combined with your annual £3,000 exemption. Your annual exemption can be off set against any proportion of gifts that do not fully comply with the qualifying conditions.

The Wedding Gift Exemption

The following lifetime wedding gift can be made exempt from inheritance tax:

  • Up to £5,000 for each of your children (including adopted children and step-children) or the person that your child is marrying.
  • Up to £2,500 to each grandchild, great-grandchild or the person your grandchild or great-grandchild is marrying
  • Up to £1,000 to anybody else

Such gifts must be made on or shortly before the marriage to one or both parties. The exemption only becomes fully effective when the marriage takes place.

If you would like any further advice on tax and estate planning, please speak to Richard Monkcom, partner, or Katie Underhill, Solicitor, of Druces LLP’s Private Client team.

This news was posted on 30 June 2016.