Craig Simpson, tax partner at Bates Weston explains the “gifts out of surplus income” exemption from Inheritance Tax.
In some circumstances it is possible to make a lifetime gift that is immediately exempt from Inheritance Tax (IHT), meaning it is not necessary to survive the seven years that usually qualify gifts as exempt from IHT.
The type of gift concerned is known as a “gift out of surplus income”, and applies to both outright gifts and gifts into trust.
Qualifying as a gift out of surplus income
To qualify as a “gift out of surplus income”:
- The gift must be made from post tax income, usually from the current tax year, not from capital. Cash is the obvious format, but other assets can qualify if the gifted item was purchased from surplus income with the intention of making the gift. The exemption does not apply where the gift is made from accumulated income, saved or invested over a period of years into a form that itself produces income. That accumulated income will be deemed as capital. Additionally pension lump sums and withdrawals from investment bonds are not regarded as income.
- The gift must be made from surplus The donor must be left with enough income to maintain their usual standard of living, which includes bills, subsistence, holidays and leisure activities. The donor must not have to use any capital reserves to preserve their standard of living, post gift giving.
- The gift must form part of the normal expenditure of the donor. The concept here is that the donor has a regular settled pattern of giving. One off gifts or gifts for a special purpose will not qualify. Examples of a settled pattern include regular standing orders, payment of grandchildren’s school fees, paying a series of premiums for life assurance. Commonly HMRC looks for a three or four year time span, regular frequency (from bi annually to monthly) and similarly sized payments. Evidence of regular payments or a commitment to make such payments out of surplus income is the key.
Reservation of benefit
If the donor derives any benefit from the gifts given, the gifted property will be treated as if it remains in the donor’s estate at their death. These are the normal “reservation of benefit” rules and they do apply to gifts out of surplus income.
How to claim the gifts out of surplus income exemption
The exemption is not given automatically. It must be claimed via IHT403, which requires the deceased’s executors to list all lifetime gifts made within 7 years of death and to substantiate a claim for gifts out of surplus income with details of all sources of income and expenditure, to arrive at surplus income remaining and the gifts made out of that surplus.
If you are considering making a gift out of surplus income, please do get in touch.
As always, you are reminded that this article is generic in nature, and you should take no action based upon it without consulting your professional advisor.
