Gifts out of excess income: a valuable inheritance tax exemption

Most people are familiar with the fact that it’s possible for someone to make gifts to other individuals during their lifetime without there being an immediate inheritance tax (IHT) charge.  This is called a potentially exempt transfer, or PET. As long as the person making the gift (the donor) survives seven years, and doesn’t continue to benefit from the assets gifted, the PET falls out of account for IHT purposes.  But if the donor dies within seven years of making the PET, IHT may be payable on that gift.  Even if IHT is not payable, it may use up all or part of the donor’s nil rate band (the amount that everybody may leave free of IHT on their death if it has not already been used).

There are a number of exemptions that can apply to gifts, including gifts to spouses, civil partners or charities, but there is another valuable exemption that can help reduce IHT bills.  This is known as the normal expenditure out of income exemption, or gifts out of excess income.

What is normal expenditure out of income?

Normal expenditure out of income is an IHT exemption available when a person regularly gives away part of their surplus income, i.e. income left over after meeting all their usual living costs, without reducing their overall standard of living.  What is relevant is the donor’s usual standard of living, rather than a standard set by anybody else including HMRC.

To qualify for the exemption:

• The gift must be made from income, not capital
• The gifting must form part of a regular pattern
• After the gifts, the donor must still have enough income to maintain their usual lifestyle.

When these conditions are met, the gifts are immediately exempt from IHT, with no need to wait for seven years.

It may be possible to claim the exemption during the donor’s lifetime where they make gifts to trusts, although HMRC will only confirm that the exemption applies where IHT is at stake (i.e. where the available IHT nil rate band is exceeded) and an IHT account is submitted.  Where the full nil rate band is available, that would only be after cumulative transfers in excess of £325,000 in a seven year period.

Why is this exemption so useful?

This exemption is valuable because:

• It allows individuals who have income in excess of their needs to reduce the value of their taxable estate quickly and efficiently, without waiting seven years for PETs to fall outside their estate
• It offers flexibility – the amount gifted and the beneficiaries can change at any time
• It can help support a range of family members or friends on a regular basis, (e.g. covering a child’s rent or grandchild’s university fees)
• It can be used to fund a lifetime trust, giving donors control as trustees while still passing wealth to beneficiaries in a tax-efficient way
• It avoids using capital, preserving investment portfolios or savings.

Overall, it is one of the most effective and underused IHT exemptions.

How does it work?

The exemption will most often be claimed after the donor has died, so the claim will be made by their personal representatives.  As you would expect, HMRC wants to ensure that all the conditions are fulfilled before granting the relief, and the personal representatives will need to complete a detailed form setting out not only the donor’s net income each year, but their expenditure across different areas to ensure that their standard of living is maintained.

To use the exemption, a donor will need to:

1 – Identify surplus income

Calculate their annual income (salary, pensions, dividends, interest etc.) and deduct their usual household outgoings as well as tax paid.  The figure remaining after those deductions is excess income.  Full details of the income and expenditure information that will be required by HMRC are set out in the final section of this information sheet.

2 – Establish a regular pattern of giving

The donor should decide how they wish to gift the surplus.  It can be monthly, quarterly or annually. Consistency matters more than frequency.  HMRC usually expect to see gifts being made over a period of years, but as long as the intention is clear, shorter periods have been accepted.  Consider writing to the recipient(s) to tell them of your intention, or even letting your solicitor know what you plan to do.  There is no need to refer to the exemption, simply to the intention of making regular gifts.

3 – Make the gifts

Gifts can be made:

• Directly to beneficiaries (e.g. to an adult child), or
• Into a lifetime trust established for them, allowing you to remain a trustee and maintain control over how the funds are used.

4 – Keep records

This is very important and may determine whether a claim will succeed.  The donor should keep a record showing:

• Income after tax each year (this can be obtained from tax returns, but will also include tax exempt income such as interest on cash ISAs, if paid to the account holder) as set out at the end of this information sheet
• Routine expenditure in the categories set out at the end of this information sheet
• The pattern of giving (i.e. dates and amounts of gifts and identities of recipients)
• Confirmation that the gifts came from income.

If HMRC agrees the gifts meet the exemption criteria, they are fully exempt from IHT and have no impact on the available nil rate band.

What counts as income?

Income for this exemption is income for accounting purposes, so includes interest, dividends, rental income, salary etc and even non-taxable income from ISAs, for example, counts as income.  Note that the 5% tax free withdrawal from an investment bond does not count as income.  Withdrawals from a pension fund should be treated as income if there is some regularity, rather than a one-off withdrawal of the tax-free lump sum, for example (although HMRC have not issued any guidance on this).  If you are in any doubt whether something constitutes income, speak to your solicitor or accountant.

Income and Expenditure records

HMRC ask personal representatives to complete a form (IHT403) to determine whether the exemption applies, for each tax year in which the exemption is claimed. The donor’s personal representatives will need to give annual figures for each of the following:

Income

• Salary
• Pensions
• Interest
• Investment income
• Rental income
• Annuities
• Any other types of income
• Less tax deducted from that income.

Expenditure

• Mortgage
• Insurance
• Household bills
• Council tax
• Travelling
• Entertainment
• Holidays
• Nursing home fees
• Other types of expenditure (e.g. insurance policies premiums).

It is hard for personal representatives to reconstruct these figures after a donor has died, by reviewing tax returns and bank statements, especially if they have to go back seven years.  This can add substantially to the cost of administering an estate.  For that reason we strongly recommend that donors keep ongoing records to facilitate the claim, as well as documenting their intention of making regular gifts.

If you require further information, please contact Fiona Higgott or Georgette Valentine