It is generally well known that in order for a gift to be effective for inheritance tax (IHT) purposes, you need to survive the gift by seven years. That is true for gifts of capital.

But, what is less well known, is that there is a special exemption for gifts of surplus income. Such gifts can be exempt from IHT immediately: there is no need to survive seven years.

Requirements

For gifts of income to be immediately exempt from IHT they must:  

  • be gifts of income and not capital
  • not be so great as to result in you having insufficient income left over to maintain your usual standard of living
  • be made as part of a settled pattern of giving, rather than on an ad hoc basis, so that the gifts constitute part of your normal expenditure  

How much can you give?

There is no limit to the amount you can give away. As a rule of thumb, look at it as a gift of surplus income that would otherwise have been available for saving. Provided the above conditions are met, the entire amount should qualify for immediate IHT exemption.  

When should I make the gifts?

There is no strict rule as to when the gifts should be made. However, in order to demonstrate that the income is surplus to your needs, perhaps the better time to make the gifts is towards the end of each tax year when you have a clear idea of your income and (likely) expenditure for that year. Alternatively, if you want to get ahead, set up a monthly or quarterly standing order of a “safe” amount and “top up” at the tax year end.

For how many years should I make the gifts?

Again, there is no strict rule. However, in order to demonstrate that the gifts are being made as part of a settled pattern, it is advisable that you continue to make the gifts over a number of years. Or at least you should demonstrate the intention from the outset to do this.

Much will depend on your circumstances, eg your age and affordability.  

Demonstrating a settled pattern of giving comes down to the written evidence. This is crucial in order to reduce the risk of HM Revenue & Customs successfully challenging the effectiveness of the gifts. This also makes the task of administering your estate much easier for your executors and thereby reduces the time and costs of the exercise.

What if I lose mental capacity?

Attorneys are not normally empowered to continue making gifts on behalf of people who are losing (or have lost) mental capacity unless they make a time consuming application to the Court. This can be awkward for family members who are dependent on receiving regular gifts, eg to pay school fees. Fortunately, we have pioneered a special technique which can be put in place to avoid the trouble and expense of your attorneys having to make a court application.

Should I pay the money into a nominated account for my children or grandchildren?

No. Nominated (or designated) accounts are inflexible and can create problems in the future.

For example, when the child reaches the age of 18, they can call on the funds in the account to be paid to them. For obvious reasons, this is likely to be inappropriate: the child will be entitled to spend the money as they wish which, at that age, may well be in a way in which you disapprove.

Even if they do not call on the funds, there are significant disadvantages if the funds are held in a nominated or designated account.

  • The funds will be exposed to IHT on the child’s death.
  • The funds will be exposed to a claim by a divorcing spouse. 
  • The funds will be exposed to a claim by a creditor.  

In short, using a nominated or designated account will not protect the funds and is unlikely to have achieved what you intended.  

Protect the gifts: use a trust

These problems can be avoided by using a suitably drafted trust. Gifts made to a trust have a number of advantages:

  • you can act as trustee which will give you control of how the funds are invested and distributed 
  • the funds (and any growth) will not only escape IHT on your death: they will also escape IHT on your beneficiaries’ deaths 
  • the funds are protected from potential nontax threats such as divorce or the financial vulnerability of the beneficiaries 
  • if only one of you and your spouse (or civil partner) is making the gifts to the trust, the other of you can benefit from the trust as well as the other beneficiaries (eg your children or grandchildren)
  • the structure can be particularly attractive for funding children’s education costs and providing funds for them in an IHT efficient way, eg to help them with the purchase of their first property