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.