There is a real concern that the inheritance tax rules may be due for a change. A couple of recent reports give an outline of the areas that may receive attention. One of these is the exemption for “normal expenditure out of income” and clients who can use this exemption may like to take early action.
Despite a recent little dip because of the impact of the residence nil rate band, inheritance tax (IHT) receipts are on the rise again and are comfortably over £5 billion per tax year. The tax was payable on 4.6% of estates of those who died in 2016/17 – up from 2.6% in 2009.
One of the most effective ways of combating IHT is to make lifetime gifts. There are potentially four drawbacks to this:
- To be fully effective for IHT purposes the donor needs to survive seven years.
- If the donor wants access to the property gifted, the gift with reservation of benefit rules will neutralise any potential IHT savings.
- Will any capital gains tax arise on the gift?
- The donor may be concerned over the loss of control over the asset gifted.
All four of these drawbacks can be overcome if proper planning is undertaken. For example, if gifts are made regularly out of the donor’s surplus income, and those gifts do not affect the donor’s standard of living, they will be exempt when made – no need to live for a further seven years for IHT effectiveness.
Because those gifts are of cash, no CGT issues arise. Further, because they are made out of surplus income, there is probably no requirement for the donor to have future access to the gifts and control can be exercised over the gifts by making the gifts into a trust.
And remember, all income can be taken into account for these purposes – earned income, investment income and tax-free income, such as that from ISAs and flexi-access drawdown income from an income drawdown account where the pension scheme member died under age 75.
George is aged 57 and enjoys income of £150,000 per annum (£110,000 net) from his job as an architect. He and his wife, Samantha, have combined taxable estates of £3m and so face a hefty IHT charge of more than £900,000 on the second death. His sons, Robert (14) and Richard (12), are showing academic promise and are likely to go to university. He would like to put in place some funding to help them.
George has surplus income of about £20,000 per annum. He thinks it would be good to use £10,000 of this to make a regular annual gift to a trust fund for the benefit of Robert and Richard. As each gift would be exempt under the normal expenditure exemption, there are no tax consequences on the gift and no requirement to live seven years for it to be IHT effective. The trustees invest in funds which are appropriate to the need to be drawn down over the next four to eight years.
So, this all works very well for George. But he needs to bear in mind two important facts about the normal expenditure exemption:
- Because the donor’s personal representatives (PRs) will probably need to claim the exemption on those gifts made within seven years of the donor’s death, it is best if the donor can leave full details of the circumstances of each gift when made, in particular, that it is made out of income and does not affect his standard of living. In this respect it is worth the donor completing the form IHT 403 (Return of gifts and other transfers of value) to give his PRs guidance.
- The Office of Tax Simplification recently produced a report on the simplification of IHT in which they proposed that the annual exemption, the marriage exemption(s) and the normal expenditure out of income exemption should be bundled together as one exemption of about £25,000 per annum. More recently a cross party committee of MPs have suggested the Government make more radical changes to IHT. One of these would be to remove the normal expenditure out of income exemption.
So, what should clients do? Well, it is impossible to predict whether changes to IHT will be made by the Government in the forthcoming Budget or over the next year or two. But, given the healthy majority the current Government enjoys, there must be a chance that the system will, at the very least, be simplified. It also means that clients that can afford to make substantial gifts out of income may like to get that planning up and running before any rule change occurs – in the hope that if a rule change does occur, existing arrangements will be protected.
If clients implement this planning now, it would make sense:
- to evidence, in writing, the intention to make regular gifts to show they form a pattern of gifting;
- to keep records of expenditure so that it can be shown that any payments out of income do not affect their standard of living; and
- ideally complete form IHT403 which records gifts and expenditure and may help the client’s PRs to deal with any queries that arise from HMRC after the client’s death.