Richard Grimster
Partner
Gifting out of income: A useful but often overlooked IHT exemption
For those in the right circumstances, making gifts out of income can be a highly effective way to reduce Inheritance Tax (IHT) exposure. Unlike Potentially Exempt Transfers (PETs), regular gifts made from surplus income are immediately exempt from IHT, provided certain conditions are met.
This relief is particularly attractive for individuals with consistent excess income who wish to prevent their IHT liability from rising, without diminishing their capital. Although often underused, gifts out of income can be a valuable part of an overall estate planning strategy, especially when combined with other gifting methods.
In this blog, we’ll explore what gifts out of income involve, who is best placed to benefit, the key conditions to be aware of, and how to maintain proper records to ensure the relief is successfully applied.
What are the conditions for making gifts out of income?
In order for a gift to qualify for this exemption it must form part of the donor’s normal expenditure, it must be made out of their income, and it must leave the donor with enough income to maintain their normal standard of living.
One of the key challenges with gifts out of income is proving to HMRC that the gifts genuinely meet the necessary conditions to qualify for the IHT exemption. HMRC often scrutinise gifts during probate (i.e. after the donor has died) and without sufficient evidence, there’s a risk that the exemption could be disallowed.
It is therefore essential that good record keeping of gifts and how they have been funded is maintained.
In practice, this means having clear evidence of:
- The donor’s regular income and surplus income amount
- The intention to make the gifts out of that surplus income
- A consistent pattern of gifting over time
In order to satisfy that a gift is made out of ‘normal expenditure’ there needs to be some regularity to the gift being made. In theory you could make a gift once a year, every year and that’s enough to establish a pattern, however fewer payments make it harder to meet HMRC’s requirements. It will almost always be recommended that more frequent gifts are made, such as monthly or quarterly gifts.
What counts as income?
Income for this relief generally includes most items that are taxable as income, for Income Tax purposes, such as:
- Pension income
- Salary
- Dividends and interest income
- Rental profits
It is important to note that the burden is on the taxpayer to prove that the gift is made out of income, rather than HMRC to prove otherwise.
What counts as surplus income?
As the name suggests, the surplus is simply the income received in a particular period that is not needed to maintain a normal standard of living. Another way of thinking of this is that amount of income that has been ‘saved’ rather than spent.
How do gifts out of income compare to other immediate exemptions?
The main benefit of this exemption is that the amount that can be given away is personal to each person – it is the amount of surplus income they have in a particular period. This often means the limit of the exemption is significantly higher than other exempt gifts, such as those listed below:
- Annual exemption: Everyone can gift up to £3,000 per tax year tax-free.
- Wedding gifts: Gifts made on family weddings are exempt up to certain limits (e.g., £5,000 for a child’s wedding).
Again, this exemption isn’t limited by a fixed amount. It’s limited by the income received in a year that you’ve not spent, so limited only by your personal circumstances.
I’d like to make a gift out of income, however I’m worried about giving away too much too soon?
Many people want to reduce their IHT liability, but feel uneasy about losing control of assets or giving away large sums too early. In these cases, a Trust can be useful.
By placing your gifts out of normal expenditure into a Trust, you can make a gift for IHT purposes while still retaining an element of control over how and when the money is used. For example, a Discretionary Trust will name a group of potential beneficiaries, and the trustees can decide who might benefit, when they receive funds, and for what purpose – such as education costs or a house deposit.
Trusts can be particularly useful if your intended beneficiaries are still young or not yet financially mature.
It’s important to note that Trusts come with their own set of tax rules and administrative requirements, so they aren’t suitable for everyone.
Is there a timeframe for gifts out of income to be made after income received?
While the legislation doesn’t set a fixed timeframe, HMRC guidance suggests that income retained for more than two years is likely to be treated as ‘capital’. Once this happens, it no longer qualifies to be given away within the exemption for gifts out of income.
The principle behind the relief is that the gifts are being made as part of the donor’s regular outgoings, rather than as a gift of accumulated savings or capital. Delaying the gift of surplus income, or simply letting it build up unspent for a period of time, may risk HMRC challenging the exemption.
As a general rule of thumb, the sooner the income is gifted, the less likely HMRC are to question if the exemption can apply to it.
Is the Government likely to change the rules?
Despite the recent focus on IHT, there’s been no indication that this exemption is under review.
That said, it is common for HMRC to challenge this exemption during probate and if the donor hasn’t clearly met the conditions or maintained proper records, it’s easy for the relief to be denied.
How can Price Bailey help?
We support clients by reviewing their overall inheritance tax exposure and ensuring that any gifting strategy is aligned with their wider estate planning goals. It’s important to consider gifts out of income in the context of other available IHT reliefs and mitigation options.
To help strengthen the claim for exemption, we can suggest appropriate ways of documenting evidence of the gifts being made and the donor’s intentions at the outset.
Our IHT, Probate and Will specialists all work closely together, helping you to ensure that any gifts made are properly recorded and understood for future estate administration.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.
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