Making gifts in lifetime is one method of reducing potential exposure to IHT on death, whilst also allowing the donor to see the benefits that their gifts provide.  A gift made in lifetime to another individual is treated as a Potentially Exempt Transfers (PET).  If the PET is survived by at least 7 years the value of the gift will not be subject to IHT, providing the donor does not retain some right or benefit over the asset gifted (known as “reservation of benefit”).  An invaluable and underused IHT relief for gifts, claimed by less than 2% of IHT paying estates in the three tax years to 5 April 2022, is the exemption for regular gifts made out of surplus income.

The exemption for regular gifts made out of surplus income allows gifts to immediately fall outside of the donor’s estate, rather than being subject to the usual 7-year survivorship rule.  There is also no limit on the value of the gift that the exemption can apply to, with the limit instead simply based on the level of the donor’s surplus income.

For the gift to qualify for the exemption, it must be shown that:

1. The gift was made as part of the donor’s normal expenditure.
2. The gift was made out of income, and
3. That after allowing for the above, the donor retained sufficient income to maintain their usual standard of living.

Meaning of “normal”

To be considered “normal”, the gifts should be recurring, with a regular pattern of gifts established.  The frequency, amount, and nature of the gifts, as well as the identity of those receiving them are all relevant factors that could support gifts as being “normal”.

There is no set time span or minimum number of gifts required to establish a normal pattern of giving but HMRC accept that three to four years would normally be reasonable.  Recording an intention at the time gifts are first made is also helpful in showing a commitment to making regular gifts.

Made out of income

Income for this purpose includes taxable income (such as bank interest, dividend income, rental income, employment income, pension income, etc) and non-taxable income (such as that received in an ISA, or in certain cases the tax-free cash element of pension withdrawals).  Generally, HMRC take the approach that income retains its nature for a maximum of two years, becoming capital after that point.

Usual standard of living

Importantly, gifts must be made from surplus income, after normal expenses including tax have been paid.  The exemption is not, therefore, available if the donor draws on capital to maintain their lifestyle.  The usual standard of living is specific to the donor at the time the gift is made.

To make use of this exemption, maintaining good records of income, expenses, and gifts is of fundamental importance, particularly as the exemption will typically be claimed by Personal Representatives following death.  Recording an intention to start making regular gifts out of income is also sensible.

Data provided by HMRC suggests that the relief for making regular gifts out of surplus income is currently underutilised.  With changes to the IHT regime for pensions on the horizon, there may well be an increase in future claims.  To make use of the relief, it will be important to carefully review personal circumstances to ensure all of the necessary conditions can be met.

If you are concerned about your potential IHT exposure, please contact Matthew Brown or your usual Shaw Gibbs contact, to discuss IHT planning strategies.