On a basic level, estate planning involves reducing the value of your estate to mitigate Inheritance Tax (IHT) payable upon your death. One way of doing this is to make lifetime gifts to your children.
Potentially Exempt Transfers (PETs) and the 7-Year Inheritance Tax Rule
If you give money or assets to your children these gifts are known as Potentially Exempt Transfers (PETs) (an outright gift by one individual to another). If you died within 7 years of transferring funds / the asset, then the gift becomes a ‘chargeable transfer’, and the value is aggregated with the value of your estate on death for the purpose of calculating IHT. The sooner such gifts can be made, the sooner that 7-year clock starts ticking so that the value is no longer in included in your estate for IHT.
To avoid the 7-year rule you could look to make gifts out of your surplus income. This involves a 3-part test:
- it would only work if the gifts were made out of your income
- they were part of your normal / typical expenditure
- you are left with sufficient income, in order to maintain your usual standard of living
Criteria for Surplus Income Gifts in IHT
It must be gifts made from surplus income after tax and income includes normal earnings, pension interest, interest from savings, dividend income, rental income or income payments from a trust etc. It will also include income from ISAs and attendance allowance payments even though these are not taxable. It will not include regular payments from life assurance investment bonds as these are usually considered capital payments.
Record-Keeping and Exemptions
Normal / typical expenditure does not mean that you have to make the gifts at the same time every month or every year or even the same amount each time, but you have to be able to show there is a regular pattern of gifting (albeit at differing intervals or varying amounts).
After making the gifts, if you need to rely on your capital in order to meet your usual expenditure, you would not be able to claim this exemption as you are not satisfying the third part of the test, ie you have not been left with sufficient income.
If making gifts out of surplus income is an option for you, you would need to identify your sources of income and what surplus you can afford to give away. You should keep proper records of your income and expenditure so that, upon your death, your Executors can easily identify your surplus income in any one tax year (refer to Form IHT 403 – the schedule completed about gifts in your estate’s IHT return). Written communications with your advisers (or the recipient of the gift) setting out your intention to establish a regular pattern of gifting would also act as a record of the gift. A written resolution can set out your intention for future payment and secure past payments, to the extent to which they qualify.
Don’t forget about the small gifts exemption (you can give away £250 per year to any number of people) and the annual exemption (£3,000 a year which can be increased to £6,000 if you didn’t use this exemption in the previous year) – although relatively small, can prove useful in mitigating tax if used consistently over a number of years, e.g. if a couple use their annual allowance every year for 10 years they would save £24,000 for their estate.
Reservation of Benefit in IHT and Tax Implications
Ensure that with any gifts you make you do not retain a ‘reservation of benefit’ i.e. possession and enjoyment of the gifted asset must be assumed by the recipient at your exclusion. By way of a simple example, if you gave your house to your children but carried on living there this would be a gift with reservation of benefit (GROB) and would form part of your estate for IHT purposes. Unfortunately, there would also be an IHT charge if one of your children died as the property belongs to them – so a double hit of IHT.
If, however, you pay a market price for use or possession of the gifted asset, no benefit has been retained because of consideration paid and there is no GROB. In the above example, if you paid your children market rent to continue to live in the property it would not be a GROB.
Please note that even though a GROB as a legal transfer may be ineffective for IHT it is still effective for Capital Gains Tax (CGT), i.e. transferring ownership of your property to your children may trigger CGT or result in tax consequences for the future.
Seeking Legal Advice
Obviously, any lifetime gifting will need to be balanced against ensuring that you are left in a comfortable financial position for the rest of your lives.
This is just one element of estate planning, and we would be happy to talk this through with you to help you understand the bigger picture and see if there are steps you should be taking to mitigate IHT. Please get in touch if you’d like to learn more.