There are various exemptions for lifetime gifts, such as for small gifts (under £250 per person per year), and an annual exemption of £3,000, but any other gifts remain part of your estate for IHT purposes for seven years after they were given away.
There is another important exemption, however, which more people should be aware of. Section 21 of the Inheritance Tax Act 1984 says that a gift to another person is not to be included in the seven year total if it passes all three of these tests:
It was part of your “normal expenditure”
It was made out of your income
Making it did not affect your normal standard of living
Each of these three tests must be passed, and none of them is as simple as it appears at first:
In order to be considered “normal”, the gift must be shown to be part of a pattern. If you have given £5,000 to each of your children every year for the last three or four years then this test is clearly passed, but it is possible to establish a pattern in less time than this. This is one case where a deed of covenant can be useful as it is a binding legal promise to pay a certain sum at specified intervals.
The gifts do not have to be given every year, but they do have to form part of a regular pattern. When starting a sequence of such gifts, it is normal practice (if a deed of covenant is not used) to write a letter saying something to the effect that you intend to make similar gifts in future years, though this is not essential – and it will not help if in fact you do not make the future gifts.
The gifts do not have to be to the same person, but they do have to be to the same class of people. For example, you might have three children and give £10,000 to one of them in one year, £10,000 to another the next year, and so on. That would qualify, but if instead you gave £10,000 to charity every year, you could not in one year give £10,000 to a child instead and claim that was part of the annual pattern of a gift of £10,000 – a child is not the same as a charity.
The sums given must be roughly the same every year – this does not have to be precisely accurate, but each gift must fit the pattern and not be an exception to it.
“Out Of Income”
This means made out of the income for the year in question, not out of savings from previous years’ income, but the legislation does say the test is to be done “taking one year with another”, so if you have established a pattern of “normal” giving that came from your income, the fact that in one year it came out of last year’s income (because, for example, your business had a bad year, or because you were between jobs) will not spoil the pattern.
Because the gifts must be “out of income”, a gift of a capital item, such as a painting or some shares, would not qualify unless you can show that you bought it with income in that year for the purpose of giving it as a gift. In other words, if you use income to buy a gift that syou then give away, that will qualify, but if you give (say) a painting you have owned for some time to your nephew, that would not count because it was not given “out of income”. Be careful here – unless you regularly give things rather than cash, you may still fail the “normal” test – it is safer to stick to cash.
“Usual Standard Of Living”
The final test is the hardest and the one that calls for some good record keeping. You must be able to show that after making the gift, you had enough income to maintain your usual standard of living. Notice that you must have enough income; having to live on capital after making the gift will lose you the exemption.
Once again, there is a “taking one year with another” tolerance, so just because you have a bad year, you will not lose the exemption if things subsequently improve and you are able to continue to make the gifts out of income in future.
Although this exemption is usually deliberately achieved as a result of tax planning advice, anyone dealing with the estate of a deceased person who had a good income should check to see if some or all of the gifts given in the final seven years of their life might benefit from this exemption. Whether it is due or not is a question of fact, and if the gifts pass the three tests described above, the exemption is due, even if the deceased did not deliberately set out to achieve it.
If you want to try to qualify for this exemption, make sure you take advice before starting. This article has only scratched the surface of the subject and there are many pitfalls. To take just one example, capital repayments from certain bonds and payments to nursing homes out of “lifetime care plans” are not income for the purposes of this exemption.