I am in the fortunate position of a substantial income at the age of 69. I run my own business and also have a survivor’s final salary pension from my late husband’s work.
My estate is large enough that I will get hit by inheritance tax, mainly due to the family home.
I understand that I can give money away that will remain outside the inheritance tax net if it is from surplus income.
I could probably do this, but how do I prove it is from surplus income – and more importantly how would my executors prove it if I died?
Inheritance tax: How do you prove you made regular gifts out of income surplus to your needs?
Ian Dyall, head of estate planning at Tilney, replies: A common strategy to mitigate inheritance tax is to reduce the taxable estate by making gifts.
Normally the donor needs to survive the gift by seven years before it reduces their liability. However, if the gift is covered by one of the inheritance tax exemptions it is immediately effective.
One of the most valuable exemptions for people with income surplus to their needs is the exemption for ‘normal expenditure out of income’ (section 21 of the Inheritance Tax Act 1984).
For this exemption to apply it must meet three conditions:
- It was made out of income (‘taking one year with another’, which I explain below)
- It was part of the ‘normal expenditure’ of the donor
- The donor was left with sufficient income to maintain their standard of living.
What counts as income?
Income not only includes earnings and pensions, but would also include dividends, interest, rent and other forms of income. However, there are investments that may produce payments that you consider as income, but would not be classed as income for this purpose.
Ian Dyall: The area most tested in court cases is what counts as ‘normal expenditure’
The most common of these would be regular withdrawals from life assurance bonds.
Also, if you have bought an annuity with funds other than your pension fund (called a ‘purchased life’ annuity) then part of the income you will receive is deemed a return of your capital and cannot be included for this purpose.
As a business owner it may be that your income varies from one year to the next. HMRC’s starting point will be to see whether you had sufficient income in each tax year to cover the gifts you made without affecting your standard of living.
However, the phrase ‘taking one year with the next’ in the legislation means that those with variable income may be able to make gifts in excess of their surplus income for an individual year, provided that the income over a period of years was sufficient to cover the gifts.
HMRC is likely to examine cases where the taxpayer wishes to carry forward more than two years’ income.
What is normal expenditure?
The area most tested in court cases is what counts as ‘normal expenditure’. There is no legal definition of ‘normal expenditure’ so the common meaning would apply.
For these purposes ‘normal’ means normal for the donor based on their circumstances, not for the average person. Generally this means that the gifts need to be regular both in terms of frequency and value.
It cannot be a single gift unless there is evidence that the gifts were intended to be regular but the donor died before the pattern could be established.
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For example, they paid the first of a series of premiums on a life assurance policy. For this reason it is often useful to make the payments using a direct debit as it supports the intent to make the gifts on a regular basis.
HMRC recognises that gifts may be made with reference to an income source that varies, for example dividends, or to cover specific costs which may vary in amount, such as school fees.
Capital expenditure, such as an extension to your home would not be included as expenditure for this purpose.
But regular gifts could be for anything, including contributions to a pension, or paying money into a trust to save for minor grandchildren.
If it’s for something like paying a set sum every month into someone’s Isa, bear in mind that only parents, not grandparents, can fund junior Isas.
Also, only an individual investor can pay into an adult Isa, although money could be given to the individual so that they themselves can put it into an Isa.
How do my executors prove I followed the rules?
In order to claim the exemption, on your death your executors will need to complete a table that can be found on page 6 of the IHT 403 form.
It outlines your net income, broken down into categories, and your net expenditure for each year that they claim you were making exempt gifts.
This highlights whether there was surplus income after expenditure, and is used by HMRC to assess whether the gifts made were from normal expenditure and whether they affected your standard of living.
Unless you keep an accurate record of these figures as you go along, it will be very difficult for your executors to complete the form accurately.
The easiest way to do this is to complete the table each year as you complete your tax return and ensure that you keep supporting evidence in a place where your executors can find it.
It may also be worth documenting your intent to make regular gifts via a letter stating that you intend to make similar gifts each year.
This could be particularly useful should you die within the first few years of starting the pattern of gifts. There is no set time span to establish the pattern, though HMRC seems to see three to four years as reasonable.
|Years between gift and death||Tax paid|
|Less than 3||40%|
|3 to 4||32%|
|4 to 5||24%|
|5 to 6||16%|
|6 to 7||8%|
|7 or more||0%|
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