Christmas and New year giving – essential IHT planning strategies

Learning Objectives

• Familiarise yourself with the main exemptions from inheritance tax (IHT), how they interact and how they can be maximised;
• Discover the tax benefits of making larger gifts either outright or via a trust;
• Understand the ways in which trust-based schemes can be used to secure IHT savings without loss of access to the gifted funds for the client

Christmas has long been a time for giving and, with many clients potentially minded to be more generous than usual over the coming weeks, December presents a great opportunity for advisers to talk to clients about the power of giving on the eventual inheritance that they plan to leave to their loved ones.

While Barbies and Lego will undoubtedly gain popularity points with the little ones on Christmas Day, cash or other financial gifts can also help set children and grandchildren up for the future and may be more welcome than ever this Christmas with the cost of living rocketing and the property market showing few signs of slowing down.

Fortunately, there are many ways of making gifts in a tax-efficient manner – and in some cases, retaining control over or even access to the gifted funds.

Exempt Gifts

• Annual exemption

Every individual can gift up to £3,000 annually without any IHT consequences. Any unused £3,000 allowance from the previous tax year can be carried forward (for one year only), making financial gifts of up to £6,000 a possibility this Christmas for many. Regular use of the exemption, combined with the power of compounding over a number of years could build a nice little JISA pot which will have significantly longer-lasting value than the latest gadget.

• Small gifts exemption

The small gifts exemption facilitates the making of any number of ‘small gifts’ of up to £250 or less to any number of separate individuals. Many clients have countless numbers of grandchildren, nieces and nephews and could move relatively large sums out of their estate by using this exemption at Christmastime to gift £250 to each of, say, ten grandchildren. The exemption cannot, however, be used to partly exempt a larger gift and if gifts to any one person in the same tax year exceed £250, the small gifts exemption will be lost completely in relation to that individual.

• A Christmas wedding?

Christmas is a popular time for weddings and it is worth reminding clients who are attending a family wedding this Christmas of the opportunity this provides to (each) make further IHT exempt gifts of up to £5,000 to a child who is getting married, £2,500 to a grandchild or great-grandchild and up to £1,000 to anyone else. These exemptions apply in addition to the annual exemption and can be used to exempt the first part of a larger gift.

• Regular gifts out of income

The ‘normal expenditure out of income’ exemption allows an individual to give away surplus earned or investment income without restriction provided that certain conditions are satisfied. This exemption is hugely valuable as there is no cap on how much can be given and the amounts gifted can vary from year to year as long as some sort of regular or ‘normal’ gifting pattern can be demonstrated. So, for example, individuals can give children or grandchildren an annual Christmas present of £1,000 without a tax implication, provided they can demonstrate the money came from their surplus income. Alternatively, the pattern could be linked to regularly occurring events such as payment of school fees - and grandparents making a Christmas undertaking that the cost of a grandchild’s education will be met every year is a good way of evidencing the intention to make future annual gifts (something that will be invaluable in the event of death occurring after only one or two years of gifting). It is, however, important that the donor does not have to resort to capital (such as withdrawals from an investment bond) to maintain their standard of living having given away income, otherwise the exemption will be denied and the gifts will be treated as potentially exempt transfers (PETs) or chargeable transfers as appropriate (see below).

• Gifts to charity

Many charities will be asking for donations at this time of year and a Christmas gift to a charity registered in the UK or in the EU of any amount is exempt from IHT and so will leave the estate of the donor immediately.

Larger, potentially exempt or chargeable gifts

Gifts that do not fall within one of the exemptions from IHT will be either potentially exempt or chargeable depending on whether they are made directly to another individual or via a trust. In addition to spreading joy and goodwill, making larger lifetime gifts out of capital can give rise to significant IHT savings – especially if the effect is to reduce an estate that exceeds the £2m threshold, above which the residence nil rate band starts to be restricted, to below that amount. The client will, however, need to be able to comfortably afford to make the gift as it will not usually be possible to access the funds that are gifted outright or revoke the gift if circumstances change.

• PETs

Where a gift that is not covered by an exemption is made directly to or for the absolute benefit of another individual, it will be a PET. PETs will never give rise to an immediate liability to IHT when made, whatever the value, and will fall out of account altogether after seven years. It is, however, important to appreciate that where the recipient of a PET is an adult, they will have unfettered access to and control over the gifted amount as soon as the gift is completed. PETs are therefore most likely to have appeal to those who are looking to mitigate IHT, but have already used their nil rate band on earlier chargeable transfers (see below) and/or are happy to relinquish all control over the gifted funds to the beneficiary.

Example

Holly and Nick have an estate valued at £2.8m. This Christmas, they generously decide to gift each of their four children the sum of £200,000. Not only does this reduce their estate to £2m with immediate effect for the purposes of determining eligibility for the residence nil rate band (thereby securing an immediate IHT saving of £140,000); if they survive the gift by seven years, a further saving of £320,000 will have been made. This will reduce the amount going to HMRC on second death by a total of £460,000 and increase the children’s net overall inheritance by the same amount.

• Using trusts to make gifts

Clients who are happy to give up access to some of their wealth, but are not comfortable about giving their intended beneficiaries unfettered access to large funds, may prefer to make gifts via a discretionary trust. Again, the gifted amount will be fully outside the estate after seven years. However, unlike with a PET, there could be an immediate liability to IHT at the lifetime (20%) rate if the amount gifted exceeds the settlor’s available nil rate band. In addition, discretionary trusts will be subject to the ‘relevant property regime’ of IHT ten-yearly (periodic) and exit charges. Although such charges are unlikely to apply to smaller trust funds, it is vital to seek tax guidance before setting up discretionary trusts to ensure that full account is taken of other planning (such as earlier chargeable transfers or even PETs) that could impact on the likelihood and size of IHT charges going forward. With proper advice, measures can be taken that will help to mitigate or even avoid these charges while ensuring that the client’s overriding objectives for control are met.

Using trusts to make gifts can also be useful where the subject matter of the gift is a chargeable asset such as a property or company shares as any gain can be deferred (i.e. passed on to the trust and ultimately to the beneficiaries) by making a gift hold-over relief claim. The availability of hold-over relief thereby provides the opportunity for clients to make gifts of assets that could not otherwise be removed from the estate without crystallising a gain and incurring a capital gains tax liability.

• Consider packaged schemes for IHT and income tax-efficient access

Where clients are unable or reluctant to make outright gifts to a trust or otherwise due to a (potential) need for access to their investments, there are a number of life-insurance based schemes that are based on established IHT principles which are acceptable to HMRC and which are usually available from the product provider at no additional cost. The most popular examples of these are the Loan Trust and the Discounted Gift Trust.

Generally speaking, the Loan Trust is most suitable for clients who are looking for flexible ad-hoc access to their original capital in return for moderate IHT rewards: the investment amount will initially be frozen at its original value for IHT purposes but will reduce to the extent that loan repayments are taken and spent during lifetime; while the Discounted Gift Trust provides the settlor with regular cash payments at a fixed, pre-determined, level (but no access to the rest of the investment) in return for an immediate reduction in the estate for IHT, with the entire investment IHT-free after seven years.

And, of course, Christmas is an occasion where families get together and so provides the perfect opportunity for parents to discuss recommendations, financial plans and intentions with their children and, where relevant, obtain signatures on any wills or trusts they are looking to put in place (once the turkey’s been eaten and the dishes done of course….).