In the realm of Estate Planning and wealth transfer, understanding the nuances of Inheritance Tax (IHT) in the UK is crucial. Among the various aspects of IHT, one often debated topic is whether gifts made from income are subject to Inheritance Tax. In this guide, we’ll explore the intricacies of this matter, shedding light on the rules, exemptions, and considerations surrounding this aspect of taxation.
In the UK, gifts made from your income can be exempt from Inheritance Tax, provided they meet specific criteria set out by HM Revenue and Customs (HMRC). These gifts fall under what’s known as ‘Potentially Exempt Transfers’ or PETs.
Understanding Potentially Exempt Transfers (PETs)
- Definition: PETs refer to gifts made by an individual that may become exempt from Inheritance Tax if the giver survives for seven years after making the gift.
- Requirements: For a PET to be exempt from IHT, the gift must be made from the giver’s income and not impact their standard of living. This means the gift should come from surplus income after accounting for regular expenses and maintaining one’s usual lifestyle.
- Regular Gifting: Regular gifts from income, such as birthday or holiday gifts, can be exempt if they’re part of normal expenditure and don’t reduce the giver’s standard of living.
Examples Clarifying the Concept
- Case Study – Birthday Gifts: Mr Smith earns £60,000 per year and has annual expenses totalling £40,000, maintaining his standard of living. He regularly gifts his grandchildren £3,000 each year on their birthdays. Since this gift is part of his normal expenditure and doesn’t impact his lifestyle, it can be exempt from Inheritance Tax.
- Case Study – Surplus Income: Ms Johnson, a retired individual, receives an annual pension of £30,000 and has yearly expenses of £20,000. She decides to gift her children £5,000 from her surplus income. As this gift does not compromise her standard of living and is made from her surplus income, it could potentially qualify as a PET exempt from Inheritance Tax.
The Seven-Year Rule
The Seven-Year Rule is a fundamental concept within the context of IHT in the United Kingdom. When an individual makes a gift during their lifetime, it may be considered a PET for IHT purposes. PETs become fully exempt from Inheritance Tax if the person making the gift, known as the Donor, survives for at least seven years from the date the gift was given.
If the Donor passes away within seven years of making the gift, the value of the gift might be subject to Inheritance Tax. However, the tax liability on the gifted amount diminishes on a sliding scale known as ‘Taper Relief‘. This means that the longer the Donor survives after making the gift, the less tax is payable on it.
The way taper relief works is that the Inheritance Tax liability decreases gradually from the initial rate to zero as time progresses. The tax is calculated as a percentage of the full rate that would have been applicable had the gift been subject to Inheritance Tax at the time it was given. The sliding scale of taper relief is as follows:
- Less than 3 years: Gift is taxed at the full IHT rate.
- 3 to 4 years: The IHT rate decreases by 20%.
- 4 to 5 years: The IHT rate decreases by 40%.
- 5 to 6 years: The IHT rate decreases by 60%.
- 6 to 7 years: The IHT rate decreases by 80%.
After seven years have passed since the date of the gift, it becomes completely exempt from Inheritance Tax, and there is no tax liability, regardless of the value of the gift or the total value of the Donor’s estate at the time of their death.
This Seven-Year Rule and taper relief system are designed to incentivise individuals to make gifts during their lifetime without facing immediate tax consequences, provided they live for at least seven years after making the gift. It also encourages long-term financial planning and gifting strategies to reduce the potential Inheritance Tax liability for Beneficiaries.
Proper documentation plays a pivotal role in validating claims for exemption concerning PETs and Inheritance Tax considerations.
- Record-Keeping of Income and Expenses: Maintaining comprehensive records of income and expenses is crucial for individuals making PETs from surplus income. This documentation demonstrates that the gifts were made from the surplus income after meeting regular financial commitments and living costs. Clear documentation showing a regular pattern of surplus income and gifting habits can support the claim that a gift is exempt.
- Documentation of Gifts: Detailed records of gifts made, including the date, recipient, and value, are essential. This documentation helps establish the timeline of gifts, especially concerning the seven-year rule for Inheritance Tax. If the Donor passes away within seven years of making a gift, these records Will be vital in determining the potential tax liability on that gift.
- Confirmation of Intent: Records should also reflect the Donor’s intentions when making the gifts. This could include documentation such as letters or statements explicitly stating that the gifts were made with the intention of reducing the estate’s Inheritance Tax liability or fulfilling a regular gifting pattern.
- Professional Advice and Assistance: Seeking advice from financial advisors or Will and Probate professionals can be immensely beneficial. They can provide guidance on the proper documentation required, ensuring compliance with tax laws and maximising the chances of successfully claiming exemptions.
- Consistency and Accuracy: Consistency and accuracy in record-keeping are paramount. All documentation should be maintained accurately and consistently over time, ensuring that it aligns with tax regulations and supports any claims for exemption.
- Review and Update: Regularly reviewing and updating documentation is essential. Changes in financial circumstances or tax laws might require adjustments to the documentation to maintain its relevance and accuracy.
In summary, meticulous documentation is key when it comes to potentially exempt transfers and Inheritance Tax. Thorough records of income, expenses, and gifts made from surplus income not only serve to validate claims for exemption but also demonstrate transparency and compliance with tax regulations.
Is Inheritance Tax Payable on Gifts Made From Income?
Understanding the nuances of Inheritance Tax regarding gifts made from income is integral to effective Estate Planning. While making gifts from income exempt from IHT is possible, adherence to HMRC guidelines and maintaining comprehensive records are essential. Seeking advice from a professional Will and Probate company can provide tailored guidance to navigate the complexities of Inheritance Tax and ensure compliance with regulations.
Essentially, exempting gifts made from income from Inheritance Tax can be a beneficial strategy when approached diligently and within the specified guidelines.
With extensive expertise in handling Inheritance Tax intricacies, ELM is your trusted guide. Ensure your legacy is protected by relying on ELM Legal Services for your Estate Planning, providing peace of mind for you and your loved ones. Contact us today at 0117 952 0698 or simply click Contact Us. Alternatively, if you would like to book a free initial meeting, you can visit our Online Wills service page.