Surplus income gifts and Inheritance Tax: are you fit for the fight?

27 February 2014

UK Inheritance Tax (IHT) is essentially a tax on capital at death but allowing unused income to accumulate over the years, in effect turning itself into chargeable capital, can increase a person’s IHT liability.

It is a common misconception that one has to survive all gifts by seven years before the gift will be free of IHT. Generally that tends to be true of capital gifts but not necessarily so for gifts of income. If it is possible to show a regular pattern of gifts, made out of income that is not needed to maintain the giver’s standard of living, then the gifts may be exempt from IHT immediately.

This is an incredibly valuable exemption for many, particularly if there is some doubt that the usual requirement for a seven year survival period can be achieved. There is no upper limit to the amount of income that can be given away, as long as the extent of the generosity does not result in the giver having to dig into capital in order to meet living expenses. Regularly giving away £20,000 of spare income over six years, for example, would save at least £48,000 of IHT. The saving could be more if that income would otherwise have been ploughed back into growth investments.

Is there any catch to all this? The exemption is written into the IHT statute, which is encouraging for the nervous taxpayer, and it is OK to manipulate asset investment to boost income for these purposes. Rather, the biggest problem is often claiming the exemption after death. Unless detailed records of income and expenditure are kept by the giver, there may be insufficient evidence available to the giver’s executors to make a successful claim. The onus is on the executors to prove their case.

HMRC now look at these claims carefully, including, in one case we are aware of, requesting seven years’ worth of bank statements and a post-death reconstruction of incomings and expenditure, which was costly for the estate to collate. Changes introduced in 2011 now mean that if there have been regular gifts of surplus income within seven years of death for which the exemption is claimed, these must be declared in an Inheritance Tax account.

Therefore, anyone whose IHT planning involves taking advantage of this exemption would be well advised to complete the schedule on the back of form IHT403 (usually submitted as part of the Inheritance Tax account after death) on an annual basis, or be prepared to leave their executors detailed instructions. The exemption is also deceptively fiddly and, particularly if the value of gifts is quite substantial, it is well worth paying an expert to confirm that the pattern of giving falls squarely within the relief.

It is important to be sure about where you stand in respect of this exemption as, if subsequent gifts are then made and prior gifts of income turn out to be chargeable rather than exempt as expected, there could be (more) IHT to pay on the subsequent gifts and some unhappy recipients.

Helena Luckhurst Author
Helena Luckhurst
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