Lifetime giving and inheritance tax: income options

Posted: 07/11/2018

It is possible to make gifts during your lifetime which are not automatically subject to inheritance tax at that point or on your death. Such gifts can achieve considerable tax savings. One option, which is proving increasingly popular, is to make gifts out of surplus income. Under these provisions, excess income may be gifted provided you can show that you are left with sufficient income after the gift to maintain your usual standard of living and you are not 'dipping in' to your capital.

An increasing number of people wish to use this exemption for inheritance tax purposes This is not surprising as there are several very attractive benefits including: exempt gifts do not eat into the nil rate band (the amount of money that you can leave to non-exempt beneficiaries before IHT becomes payable currently valued at £325,000); gifts are exempt straightaway for inheritance tax purposes without the need to survive seven years (unlike an outright gift); and if circumstances change, gifts can be stopped without losing the exemption for gifts already made. 

For some time it has been possible to claim the normal expenditure out of income exemption for inheritance tax purposes. Historically, HM Revenue & Customs (HMRC) would allow a claim for the exemption without asking too many questions, but times have changed and it is now necessary to provide HMRC with very detailed information when claiming the exemption in relation to lifetime gifts. Therefore, it is essential to ensure the following three conditions are met to achieve a successful claim and avoid HMRC challenges:

• the gift must form part of your normal expenditure;
• the gift must be made out of income; and
• the gift must leave you with enough income to maintain your normal standard of living.

With regard to the first condition, there must be a pattern of giving, for example, gifts must be made monthly or annually. A single gift can qualify for the exemption provided it was intended to be the first of a pattern of gifts and evidence exists to support the claim. It is, therefore, important to look at the frequency and amounts of the gifts, the nature of the gifts, the identity of the recipients and the reasons for the gifts.  It is also helpful to write down your intentions regarding the gifts, so evidence is available should any queries arise following death.

The second condition is that you must have made the gifts out of income. A gift of capital assets, such as jewellery or investments, does not generally qualify.

It is therefore necessary to look at the income for the year in which the gifts were made to see if there was enough excess income, after the payment of all expenses, available to make the gifts. It is possible to carry over income from a previous tax year but income from earlier years does not retain its character as income indefinitely. HMRC generally considers that income becomes capital after two years.

Finally, you must be left with enough income to maintain your standard of living after making the gifts.  Even if the gifts were made from income, they will not qualify for the exemption if you have had to resort to capital to meet normal living expenses.

The exemption is claimed following a person’s death using the supplementary form IHT403 that accompanies the IHT400 – Inheritance Tax Account. Very detailed information regarding the deceased’s income during the relevant tax years must be given as well as the deceased’s expenditure during those tax years, including household expenditure, expenditure on holidays, medical expenses and so forth. Such information can be extremely difficult to put together following a person’s death, and we recommend, therefore, that people collect the relevant information during their lifetime. Considerable costs can be saved when administering the estate, if this approach is adopted.

As well as outright gifts, the exemption can be applied to gifts made to trusts created by individuals during their lifetime. Such provision may be desirable if they want to retain some control over the use of the gifts and allows excess income to be paid into a trust where it can accumulate over time. It can be particularly advantageous when saving for children to use in the future, for example, for a house deposit or university fees.

Where the exemption applies, it can be very valuable.  It is also vital to spend time during your lifetime to secure the information needed following death to ensure a successful claim can be made. 

Making gifts out of surplus income

Issues to consider:

• ensure there is a regular pattern to your gifts (monthly/annually);
• make your gifts from income not your capital resources;
• ensure you can afford your gifts from income; if you dig into your capital any claim may be rejected;
• keep detailed records during your lifetime including why you are making the gift; what your current levels of expenditure cover and the value of the gift you are making.

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