Ada died in 2020 having made gifts of £1.4 million in the previous seven years. As her estate was still fairly big even after these gifts, effectively these gifts were brought back into charge to inheritance tax, and Ada’s executors had to pay over £300,000 tax on the gifts. Bertha also died in 2020, and had also given away £1.4 million in the previous seven years. But in her case there was no tax on these lifetime gifts. How can this be?
The answer is that Bertha has carefully arranged the timing and amounts of her gifts to fit in with the “normal expenditure out of income” exemption from inheritance tax.
We all know that lifetime gifts can save inheritance tax providing you survive for seven years after making them; but the importance of making transfers which are exempt is that you don’t even have to survive the seven year period to avoid the tax on these gifts. Most tax exemptions depend on who you are making the gift to: so gifts or bequests to a spouse, or a charity, for example, are IHT exempt. You also get a fairly pitiful annual exemption of £3,000 (an amount which hasn’t gone up in living memory, despite inflation). But the normal expenditure out of income exemption doesn’t depend on who you are making the gifts to; and isn’t limited in amount by any fixed or arbitrary statutory number.
To qualify for this exemption, your gifts have to pass two tests, and in each case the clue is in the name. The expenditure has to be “normal” that is repeated (or expected to be repeated) over a period; and it also has to be “out of income”: that is, you need to be able to show that your income is sufficient to enable you to afford to make this level of gifts regularly over a period.
Pass those two tests, and you can walk out of your front door and under a bus as soon as you like. The gifts will never come back into charge to inheritance tax.
There was one case, once, where what actually happened was a single, large, and one off payment which still was adjudged to qualify for exemption. The circumstances were these. An old lady, who had been receiving income from a trust for some years, decided that she didn’t really need this income, and in fact she never had. It had just accumulated in a bank account unspent. So she made the decision which, fortunately, was well documented in correspondence, that she would make over this trust income to a young relation, whose need was much greater than hers.
She duly made over all the lump sum amount which had accumulated from past years’ trust income – and then she promptly died. There was no regular series of gifts, therefore, and the Inland Revenue understandably attacked the executors’ claim to the normal expenditure out of income exemption.
The executors won the battle against the taxman, on the grounds that the expenditure was “normal” in that she had made clear her intention to pay over the trust income as a regular thing. It was, by definition, “out of income”, because the actual money paid over was clearly derived from the trust income that she had been receiving over the years.
So let’s look at the Ada and Bertha example in more detail. Ada’s gifts had been one of £500,000 six years before her death, another of £300,000 four years later, and another of £600,000 a year after that. In other words, the amounts given were given at irregular intervals in different amounts. Also, they tended to be far more than Ada could have afforded out her income for the year concerned. Bertha, on the other hand, who had inherited a significant share portfolio from her late husband, made regular gifts of £200,000 a year, every year for each of those seven years, making up the £1.4 million total. Her annual income was more than £200,000 (although the amounts paid don’t actually have to be traced pound for pound to the income received) and therefore the payments were treated as being made “out of income”.
These numbers are quite large, of course, and not many people in practice are going to be able to give away £200,000 a year – although many are in this position. But the moral of the above story is obvious. By making your gifts regular and smaller, rather than irregular and large, you are likely to save an awful lot of tax in the event that your life expectancy is less than seven years. Think about it, and set out a plan as soon as you can, if you are in what is referred to today as the “vulnerable” category!
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