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Gifts out of excess income

Inheritance Tax (IHT) legislation provides an exemption where you can show that a lifetime gift formed part of your normal expenditure. It’s important to understand: what qualifies to ensure you realise your tax savings, and the effective way to record such gifts.

This article is part of our Quarterly Tax Digest for individuals.

Last updated: 2 December 2020

Making a gift

When your income for a given year exceeds expenditure the surplus income is normally ‘accumulated’ (added) to your capital after 2-3 years (there is no precise rule as to when this happens).

Any gift you make would then result in a reduction of your estate and count as a potentially exempt transfer (PET) for IHT purposes. Every individual is allowed a £3,000 annual exemption. But for gifts exceeding that amount, the excess would be subject to IHT at a rate of up to 40% should the transferor die within seven years of the gift.

About the author

Nyah Duffy

+44 (0) 20 7556 1424
Duffyn@buzzacott.co.uk
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This article is part of our Quarterly Tax Digest for individuals.

Last updated: 2 December 2020

Making a gift

When your income for a given year exceeds expenditure the surplus income is normally ‘accumulated’ (added) to your capital after 2-3 years (there is no precise rule as to when this happens).

Any gift you make would then result in a reduction of your estate and count as a potentially exempt transfer (PET) for IHT purposes. Every individual is allowed a £3,000 annual exemption. But for gifts exceeding that amount, the excess would be subject to IHT at a rate of up to 40% should the transferor die within seven years of the gift.

What is a gift out of excess income?

What is a gift out of excess income?

On the other hand, if an individual gives away revenue before it loses its income character, the cash is never deemed to have been accumulated to capital, and therefore the gift is not considered a PET. Instead, it is exempt from all tax for both the donor and done, irrespective of how long the donor survives. For example a gift of £35,000 made from excess income rather than capital could present a saving of up to £14,000 of tax. 

However there are rules about which gifts can qualify: 

  • Most importantly, it must be made from surplus income. This means that, after making the gifts, the donor must retain enough income to maintain their normal standard of living.
  • Gifts must also be considered ‘normal’, by virtue of conforming to a settled pattern, which is in turn demonstrated by regular amounts or the commitment to a recurrent expenditure, e.g. school fees or life assurance premiums.
What should you consider?

What should you consider?

This form of giving is most effective for those with high income relative to their cost of living, who are either wishing to clear their estate or just make gifts to loved ones. Especially in order to distinguish these gifts from lifetime gifts of capital which have already been made or are being contemplated.

It is important to consider the conditions that must be met for gifts to qualify. The conditions of ‘surplus’ and ‘normality’ are qualitative and, without methodical planning, can leave room for doubt about the tax effects. It’s therefore advisable to seek professional advice in advance to identify any ambiguity. Inadvertently making a gift of capital could be very costly and later give rise to a 40% tax charge on the estate.

What steps should you take?

What steps should you take?

We advise you keep financial records that allow you to calculate and offset expenditure against income. This will determine the amount available for gifting. Tracking the opening and closing balances on monthly bank statements is the usual starting point. It’s also helpful to record a memorandum of intent, declaring your future intention to make regular gifts of your excess income, which can be used to anticipate a challenge to their nature.

Speak to an expert
Speak to an expert

Speak to one of our experts to determine whether gifts out of excess income will benefit you and the necessary steps to take to achieve a tax saving. 

 
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