The author of this article notes that because of of fiscal drag and ever-rising house prices making IHT a problem for more people, taking advantage of gifts via normal expenditure out of income, and other options such as pensions, will become more urgent.

Hugo Smith, a partner at BDB Pitmans, talks about the UK inheritance tax regime and the various ways in which people can mitigate its impact. Inheritance taxes, or estate taxes as they’re known in the US, remain a lively political topic in the UK. There have been calls, for example, for the UK system to be scrapped, or for thresholds at which the tax bites to be changed. Given the tough state of public finances, it might be difficult to see inheritance tax being abolished or significantly lightened any time soon. 

Until that time arrives, however, here is Smith’s article. The usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com if you have questions or wish to comment. 

Inheritance tax raises relatively little revenue for the government (around £7 billion ($8.8 billion) in recent years), but it remains a very emotional tax and, for those whose estates are caught by it, or expect to be caught by it, it is widely disliked.  

There are, however, ways of making use of exemptions and reliefs set out in legislation to reduce the inheritance tax liability on your death and it is important to take advantage of these where they are available. In this article I set out some exemptions and reliefs to be aware of. 

Housing uplift
As house prices continue to increase, more and more taxpayers are caught in the inheritance tax net and for every £1,000 increase in property values, £400 will ultimately go to the Treasury. While the Residence Nil Rate Band (introduced in 2015 on top of the ordinary Nil Rate Band) can allow married couples to leave an additional £350,000 free of tax, it is only available where the property passes outright to direct descendants, and where the taxable estate is less than £2 million. It is therefore important to ensure that your will is structured so that assets pass outright to descendants, rather than in trust for them. If your estate is around £2 million, it may be advisable to make some lifetime gifts to keep it below that level.

Under current rules, putting money into pensions is one of the most tax-efficient ways of estate planning. A modern pension fund can be left effectively free of tax to descendants as a continuing pension. Tax is only paid by descendants when they withdraw funds from the pension. Furthermore, if the taxpayer dies under 75, descendants can withdraw funds from the pension tax free. The government’s recent decision to remove limits on pension contributions provides a useful opportunity to put significant funds into pensions as a tax-efficient succession vehicle. However, given the recent history of repeated changes to the pensions regime, and given this ability to pass assets down a generation tax free has already received media scrutiny, it is difficult to rely on the rules still being as generous in future.

It is worth highlighting one of the lesser known, but very useful, exemptions called the Normal Expenditure out of Income Exemption. If you can bring yourself within this exemption, any funds gifted will pass immediately out of your estate, without having to wait for seven years, as is the normal rule for gifts.  

To meet the criteria for this exemption, a taxpayer must broadly be able to demonstrate that he/she (i) has surplus income; (ii) has given away some of that surplus income; (iii) in a pattern of regular gifts, and (iv) the gifts have not affected his/her normal standard of living.  

Meeting each of these criteria has its own challenges. The most important thing is to keep good records during your lifetime to save your executors having to reconstruct your income and expenditure after your death.  

While the exemption requires there to be a regular pattern of gifts, this does not mean that they must be identical each year either in value or in recipient, but merely to show that there is not a series of occasional or one-off gifts. If you wish to take advantage of this exemption, it can be useful at the outset to record and note that you are intending to start making regular gifts to, for example, your grandchildren from your income.  

The most difficult criteria to meet can be to show that the gifts do not diminish the taxpayer’s standard of living. One of these forms that HMRC requires your executors to complete up to your death (IHT403) contains a table recording your income and setting out the different types of expenditure that you might incur each year to show whether there is a net surplus. It is therefore a useful exercise during your lifetime to fill this in as a running table, to save your executors doing so after your death.

Important points to note are that if, for example, only one of a couple has significant income, but gifts are made by both, only the high earner will be able to make use of this exemption. It may therefore be better for only one of a couple to make the regular gifts. Equally, there can be some confusion about what qualifies as “income.” For example, you may consider regular withdrawals for an investment bond or payments from gift and loan trusts to be your income, but HMRC does not treat them as income for these purposes.

It is also important to be aware of a change in circumstances. If you are making regular gifts but either income falls or your expenditure increases (perhaps because of care fees), you may no longer have surplus income to qualify for the exemption.

However, where there is surplus income, this can be a very good way of passing significant funds out of your estate either by simple gifts or into trust, without any inheritance tax liability arising.

With a combination of fiscal drag and ever-rising house prices making IHT a problem for a greater segment of the middle class, taking advantage of gifts via normal expenditure out of income, and other options such as pensions, will become a priority for many more families. With a cut in IHT, either from the current Chancellor or a future Labour government unlikely, it is vital that families are fully aware of their options to make sure that they can pass on as much as possible to their relatives.