Gifts out of income
Making gifts from your income to avoid Inheritance Tax
One question which always gets asked: How can I reduce inheritance tax on my estate when all my capital is tied up? One answer to that question is that if you can afford it then you can make lifetime gifts of capital. This is one of the most effective IHT planning strategies.
Potentially exempt transfer (PET)
If you are in this situation and have already made use of the annual and small gift exemptions, then you might be limited to only being able to make a gift of capital, which is gifts from your income and then hope to survive the dates of making the gifts by at least seven years so that the gifts will fall out of the estate at death for IHT reasons.
This gift can be made directly and so is classified as a potentially exempt transfer (PET) or a gift into a trust which is classified as a chargeable lifetime transfer. The two types of gifts are taxed in different ways, so experienced advice is required.
Normal expenditure out of income
To be able to improve this position, you can arrange affairs so that the exemption for ‘normal expenditure out of income’ can be claimed on death. This is done by making gifts from your income that you consider you do not need to maintain your standard of living.
For you to be able to qualify then, your expenditure must be normal or habitual. It must be made out of income and after all outgoing costs, including the transfers, you must be able to demonstrate that there is no change in your standard of living.
Should you decide to use these gifts out of income method. It is essential for the intention to make the gift regular and routine is recorded. This could mean using standing order arrangements or a letter of intent for gifts that are made annually. Besides, the gifts should be of the same value as the regular payments that are made and should there be any changes to the amount gifted, the reason for the change must be recorded.
IHT form 403
To determine whether the second and third conditions have been met, HMRC expect your trustees or executors to give a lot of detail of your income and expenditure in the years before your death which would be entered on the IHT form 403. Income includes all types of income, whether it is taxable or not.
The expenses will include amounts which can be easily determined, for example, mortgage or utility bills but will also include items which cannot be easily identified, such as holidays or travel. The surplus of income over expenditure is then compared to the value of gifts which the exemption is being claimed. This is to determine whether the gifts were made out of income rather than capital.
If you hope for the estate to benefit from the exemption, then you must keep everything well documented to ensure the personal representatives have the best chance of success and don’t submit an incorrect claim.
Like all IHT planning it is essential to get experienced advice before starting any Inheritance Tax mitigation planning. Please contact us for help and advice in this area.