Briefing Note

Inheritance Tax Exemption for Gifts Out of Surplus Income

May 2019

Please note that this Briefing Note is not maintained, and reflects the law as at the date of publication or update

Introduction

This briefing note provides an overview of the inheritance tax exemption relating to gifts out of surplus income, together with some of the key issues relating to this exemption. It is intended only as general guidance and should not be relied upon as legal advice. If you have any queries concerning your personal situation, please contact us for advice on your specific circumstances.

Inheritance Tax (IHT)

Inheritance tax (IHT) is primarily a tax paid on assets upon someone’s death. Inheritance tax receipts have been steadily increasing over the last few years and in 2017/18 IHT tax receipts hit a record high of over £5.2 billion. This was the first time IHT tax receipts had exceeded the £5 billion barrier and was an 8% increase on the IHT tax receipts for 2016/17.

For further information on inheritance tax and IHT planning generally, please refer to our briefing note on inheritance tax planning.

IHT mitigation through lifetime gifts

One way to reduce your inheritance tax liability is to make gifts during your lifetime. Lifetime gifts to an individual absolutely, are treated as potentially exempt transfers. This means that if the person making the gift (the donor) survives 7 years from the date of the gift, and does not reserve a benefit in the asset given away, the value of the gift will not be taken into account on the donor’s death, for IHT purposes. If however, the donor dies within 7 years of making the gift, this will be taken into account when calculating the size of their chargeable estate for IHT tax purposes.

There are various exemptions that can apply to lifetime gifts, which would otherwise be chargeable to IHT. For example, small gifts to any one person of up to £250 in total in any one tax year are exempt. However, if the £250 limit for any one person in a single tax year is exceeded, then the whole of the value of the gifts that person has received in that tax year will be subject to IHT. There is also an exemption for gifts up to a certain limit for a wedding or civil partnership. The gift must occur on or before the ceremony and must be conditional on the ceremony taking place. There is also an annual exemption for lifetime gifts, which do not qualify for any other exemptions, up to a total of £3,000 in a tax year. Any unused portion of the annual exemption for a particular tax year can be carried forward to the next tax year only.

The exemptions mentioned above for lifetime gifts have not increased for a considerable number of years and the annual inheritance tax exemption of £3,000 has remained unchanged since 1981.

Lifetime gifts which qualify as part of your normal expenditure out of surplus income are also wholly exempt from inheritance tax. Given that the exemptions for other lifetime gifts have not increased, the exemption for gifts out of surplus income is an invaluable inheritance tax planning tool for those that have surplus income.

How the Exemption for Gifts out of Surplus Income Works

In order for a gift to be exempt as a gift out of surplus income, the following conditions must be satisfied:

  • The gift must be part of your normal (i.e typical or habitual) expenditure; and
  • The gift must be made out of your after tax income taking one year with another; and
  • After allowing for all other transfers of value forming part of your expenditure, you are left with sufficient income, in order to maintain your usual standard of living;

In order to satisfy H M Revenue & Customs that the gifts were part of your normal expenditure, it will be necessary to show a commitment to make regular gifts as part of a settled pattern of giving.

The exemption only applies where the gifts are made from surplus income after tax. Examples of income will include pension income, interest from savings, dividend income, rental income or income payments received from a trust. If you prepare income tax returns, your tax return will help you identify the sources of your income but you should remember to also take into account any income from ISAs, which will not show up on your income tax return, but which will still be considered income, for the purposes of the gifts out of surplus income IHT exemption.

If you own life assurance investment bonds and receive regular payments from such bonds, you should be aware that those payments will usually be considered as capital payments and, therefore, cannot be included as part of your income for the purposes of this exemption.

If you are having to resort to capital in order to meet your usual expenditure, you will not be able to claim that any gifts are made out of surplus exemption as you will not then be able to meet the test that, after allowing for the gifts forming part of your normal expenditure, you are left with sufficient income in order to maintain your usual standard of living.

Practical Tips

  • If you are intending to establish a pattern of giving as part of your normal expenditure out of income, we would recommend that you write a letter to the person or persons to whom you are making any gifts as a record of the gift and the letter should state your intention to establish a pattern of making further gifts out of surplus income to them in the future. This letter will then be useful evidence in establishing your intention, in the event that H M Revenue & Customs were ever to raise any queries after your death.
  • Keep proper records of your income and expenditure, so that your executors are easily able to identify your surplus income in any one tax year. You may wish to print off a copy of H M Revenue & Customs inheritance tax schedule IHT403. The last page of that schedule deals with gifts as part of your normal expenditure out of income and has various headings for income and expenditure for you to keep records. You should also keep any supporting papers confirming your income or expenditure, in the event of any queries by H M Revenue & Customs.
  • Keep a record of your income and expenditure for the two tax years prior to your first gift, as H M Revenue & Customs will usually accept that accumulated unused surplus income will only become capital after two years and you may, therefore, be able to make use of unused surplus income from a previous tax year. This can be particularly helpful for those whose income fluctuates significantly from one tax year to the next, such as people who receive royalty income.
  • Don’t forget to include income from ISAs as part of your income, as well as attendance allowance payments, which will be considered as income, although not taxable.

Conclusion

The exemption for gifts out of surplus income can be an invaluable inheritance tax mitigation tool for those that have significant surplus income and wish to establish a pattern of regular giving for their intended eventual beneficiaries.

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