Intergenerational Planning - lifetime gifting
- To understand and be able to clearly articulate and apply where appropriate the main annual exemptions from Inheritance tax
- To appreciate the difference between and tax consequences of outright gifts and gifts into trust
- To be able to apply in practice a strategy incorporating the combined use of a discretionary trust and an investment bond to carry out flexible, controlled and tax effective estate planning
Outright gifting: The fundamentals re-visited:
With asset values increasing and the inheritance tax (IHT) nil rate band and residence nil rate band being frozen at £325,000 and £175,000 respectively until the 2027/28 tax year, IHT planning is becoming of more importance as increasing numbers of individuals are being brought into the IHT net.
From a general IHT planning perspective, the extent to which planning during lifetime can take place will substantially depend on what assets the client has and the extent to which they wish to retain control over and access to those assets.
Whilst it is important to take these considerations into account and accepting that, for most, wealth transfer and IHT is likely to become more of a concern later in life, planning to mitigate and provide for IHT should not be left too late.
The starting point for anyone who is wishing to carry out lifetime IHT planning is to consider using their exemptions, the most common being:
- Annual IHT exemption – each individual can give away £3,000 each tax year, and they can use the previous tax year’s exemption if not already used; but it must then be used after the use of the £3,000 exemption for the current year.
- Small gifts exemption – up to £250 can be given to any number of individuals (note this exemption cannot be combined with any other exemption in favour of the same person).
- Normal expenditure out of income – any gift is exempt from IHT if:
- it forms part of the donor’s normal expenditure; and
- taking one year with another it is made out of income; and
- it leaves the donor with sufficient income to maintain their usual standard of living (some of these exemptions may be used by many “unconsciously” through the gifts they make throughout the year e.g. on birthdays and at Christmas)
- Gifts in consideration of marriage/civil partnership - £5,000 if the donor is a parent of one of the parties to the marriage/civil partnership, £2,500 if the donor is one of the parties to the marriage/civil partnership or a grandparent and £1,000 for any other gift.
- Unlimited gifts to registered charities, political parties or for national benefit.
- Unlimited gifts to a spouse or civil partner
Self-evidently, regular use of these exemptions over time can result in considerable IHT savings.
Once clients have maximised these exemptions, they can also consider making more substantial outright gifts either to another individual or via an absolute trust. The gift will be a potentially exempt transfer for IHT and will generally fall out of account once the donor has survived seven years.
Where individuals wish to retain control over who receives a gift and when, they could consider setting up a discretionary trust. However, in order to ensure no lifetime IHT is payable, the individual can only settle up to their available nil rate band, taking account of any chargeable lifetime transfers in the seven years prior to creating the trust. Remember that a discretionary trust is subject to the ‘relevant property regime.’ This means that the trust is subject to reporting requirements, so exit (when capital is appointed out of the trust) and periodic (ten-year anniversary) charges may apply. In practice, though, with careful planning it is possible to mitigate these charges by keeping the value of the asset given and subject to trust within the nil rate band available to the trust.
Lifetime giving in practice: a case study
Over the past 30 years Sarah (who is divorced), through gifts out of capital, has always made use of her annual IHT exemption of £3,000 in favour of her son and she has also gifted £250 to each of her three grandchildren. In doing so, she has gifted £112,500 (£90,000 using the annual IHT exemption and £22,500 using the small gifts exemption). This has resulted in a reduction of the IHT that would otherwise have been payable on her estate of over £2.3m by £45,000.
Sarah who is now 70 is well provided for with an excellent pension and no debts. She would like her family to receive as much of her estate as possible on her death. One of her friends died recently having carried out no planning and the amount of IHT payable was, in Sarah’s view “truly shocking”.
After meeting with her adviser, she is made aware that should she die, IHT of almost £800,000 would be payable. A contributor to this is that her estate will benefit from a reduced residence nil rate band. This is because the residence nil rate band of £175,000 is reduced by £1 for every £2 where an estate is over £2 million.
Wanting to “do something about that” and feeling reassured (after running some cash flow projections with her adviser) that she has sufficient funds to enjoy her relatively simple life, she decides that she would like to give £325,000 of her available cash now to benefit her family. Not only will this remove this amount from her estate but it will fully restore the residence nil rate band.
She would, however, like to retain some control over who should benefit from the amount gifted and over when they receive it.
Achieving Sarah’s objectives:
Following advice based on her clear objectives, Sarah decides to make a gift of cash into a trust under which her son, daughter-in-law, current and any future grandchildren can all be included as beneficiaries. Given her expressed objective of retaining control and flexibility a discretionary trust is chosen and she, together with her solicitor are appointed as trustees. She is happy that, once the gift has been made, she will lose all access to the amount transferred under the terms of the trust as she must be excluded from all benefit so that the trust “works” from an IHT perspective.
The discretionary trust is established with £325,000. Under this type of trust, none of the beneficiaries have any entitlement so any appointments/payments are at the full discretion of the trustees.
As the amount settled is within her available nil rate band, there would be no IHT entry charge of 20% (or 25% if paid by Sarah). For these purposes the gifts which are covered by her exemptions would not reduce her available nil rate band of £325,000. Of course, in practice she ought to keep a clear record that those gifts were covered by her annual IHT exemption and the small gifts exemption.
As the gift into the discretionary trust is of cash there would also be no capital gains tax (CGT) considerations.
To keep administration simple and to effectively manage taxation the trustees decide to invest the money in a UK investment bond. If funds are required to advance to a beneficiary then the trustees may need to make a withdrawal or encash segments/bond. A withdrawal within the tax deferred 5% cumulative allowances will not give rise to a chargeable event gain. However, if a chargeable event arose as a result of accessing money from the bond while Sarah is alive and UK resident any chargeable event gain would be assessable on her, subject to top-slicing relief if applicable. This relief may well, depending on Sarah’s other taxable income, help to reduce or avoid any liability to tax on the gain. If encashment of the bond by the trustees takes place in a tax year after Sarah’s death then any liability to tax would be assessed on the trustees at their rate of tax – effectively 25%, subject to the standard rate band which is usually £1,000.
A payment of cash from the trustees will not give rise to any income tax or capital gains tax implications.
An alternative would be for the trustees to assign individual policy segments directly to a beneficiary/ies. They could then encash them and any chargeable event gain would be assessed on them at their tax rates. This can be especially tax efficient where the beneficiary’s tax rate is lower than that of the trustees – as it would be in most cases.
In the first ten years of the trusts life (given that the transfer in was within Sarah’s available nil rate band) there would be no IHT exit charge to consider in relation to any payment of cash or assignment of segments/bond out of the trust to beneficiaries. After ten years whether any IHT is due by way of exit charge would depend on a number of factors, most importantly the amount of the transfer out of the trust.
Through the establishment of this trust not only would the £325,000 fall outside of her estate immediately and be ignored in the calculation of IHT on her death if she survives the gift by seven years , it would also immediately restore in full the residence nil rate band by bringing down the value of the estate below £2m. This means that based on current values and rates of IHT, the amount of IHT payable on Sarah’s death even if it took place immediately after the gift would be reduced by £70,000 . This saving would increase to £200,000 if death occurred seven or more years after the transfer. These savings coming , respectively from the immediate restoration of the full residence nil rate band and then supplemented by the IHT of £130,000 that would not then be payable on the amount gifted to trust .
Of course, Sarah and her advisers should regularly review all aspects of her financial plan to ensure that it takes account of changing values, legislation and her personal objectives.