How to Reduce Your Inheritance Tax Liability with Gifts

Inheritance Tax (IHT) is a legitimate concern for many people across the country, particularly as the Nil Rate Band – the available tax allowance of £325,000 per individual – has remained unchanged since 2009.

The Government’s report on taxable estates indicates that since the 2016/17 tax year, the number of estates liable to pay Inheritance Tax has increased year on year; now with approximately 1 in 20 estates being hit, which is a result of people accumulating wealth, and the average house value increasing 86% since 2009.

Following recent changes announced in Labour’s Autumn budget, this number is expected to rise further as tax reliefs such as Agricultural Property Relief and Business Property Relief are capped from 6^th April 2026, and private pensions being brought into the estate for Inheritance Tax purposes from 6^th April 2027.

Given these challenges, it is more important than ever to seek professional advice for lifetime estate planning, and also when dealing with a deceased’s estate; to ensure the mitigation of any Inheritance Tax.  One effective way to do this is by making gifts during your lifetime and Will’s Trusts and Estates expert Benjamin Davenport-Lawton explains how it is done.

Gifting as a Tax-Efficient Strategy

Gifting assets during your lifetime is a simple yet effective way to reduce your estate’s value, thus mitigating the Inheritance Tax burden. The person making the gift (the Donor) must survive for 7 years from the date of the transfer (without retaining any benefit from the gift) for it to be exempt from their estate for tax purposes. These are known as Potentially Exempt Transfers (“PET”).

If the Donor fails to survive for 7 years from the date of the transfer, and no exemption can be applied, then these are known as Chargeable Lifetime Transfers (“CLT”) and are added to the value of your estate.

Exemptions for Lifetime gifts

The Inheritance Tax Manual provides several exemptions which can apply to lifetime gifts of cash, without the value of that gift being added to the value of your estate for Inheritance Tax purposes:

• Gifts to Spouses or Charities: An unlimited amount can be transferred between couples as this is covered by “spousal exemption”, or to charities as this is covered by “charitable exemption”.
• Small Gift Exemption: Gifts of up to £250 per recipient per tax year are exempt. If the gift exceeds £250, then the entire gift must be taken into account.
• Annual Exemption: Individuals can gift up to £3,000 per tax year, which can be rolled over once if unused the previous year, but can take place more than once during the 7 year period.
• Wedding and Civil Partnership Gifts: HMRC permits gifts of up to £5,000 to a child or £2,500 to a grandchild in consideration of their marriage or civil partnership. The gift must be made before the ceremony, and if it does not subsequently take place, then the exemption is disapplied.

Gifts Out of Surplus Income – A Valuable Tax Planning Tool

One of the most effective ways to reduce your taxable estate is by making gifts out of surplus income, even if they exceed the £3,000 annual exemption. This strategy allows the Donor to distribute wealth during their lifetime, ensuring that these gifts do not form part of the estate for tax purposes.

A key advantage of this approach is that, even if the Donor does not survive the full 7 year period required for a PET, the gift may still qualify for an exemption if it is made out of surplus income. This means that money given away as part of regular, planned gifting from income can be excluded from Inheritance Tax calculations, offering a significant tax-saving opportunity.

Under Section 21 of the Inheritance Tax Act 1984, for these gifts (made within the 7 year period pre death) to be exempt, they must meet three key conditions:

1. The gift must be part of your normal expenditure:

• There must be a clear pattern of gifting and whilst there is no defined time frame, HMRC are encouraged to accept that gifts made during a 3-4 year period is normal.
• What is deemed to be “normal” is applied on a case by case basis taking into account the Donor’s usual income and expenditure.
• A single gift could still qualify as “normal expenditure” if it is intended to be the first gift in a pattern of gifts.
• Case law, such as Bennett and Others v Inland Revenue Commission, confirmed that normal expenditure can be considered in one of two ways:
  • by examining the Donor’s expenditure over time; for example, gifting 10% of the income to family members each year; and
  • the Donor being shown to have assumed a commitment, or adopted a firm resolution, regarding their future expenditure.

2. The gift must be made out of your net income:

• Eligible sources include salaries, rental income, interest, dividends, benefits (such as State Pension), private pension, etc. but this must be the net income, after the payment of relevant taxes.
• Transfers of capital (e.g., selling assets to fund gifts) do not qualify.
• HMRC generally determines that the income has become capital after a period of two years.

3. The gift must not inhibit your usual standard of living:

• The Donor must not need to dip into capital funds to maintain their lifestyle.
• If a gift results in the Donor needing to budget or use savings, it will likely be disapplied.
• HMRC assesses this on a case-by-case basis, considering changes in income over time.

HMRC’s Inheritance Tax Manual explains that the Revenue must also consider all relevant factors when determining if the gifts are exempt as a consequence of being made out of normal expenditure. This includes the frequency, the amount and the intention of the gifts.

Practical tips for Gifting out of income

• Maintain clear records – Keep detailed logs of your income and regular expenses and calculate how much surplus income you have left. From here, you can identify how much you can reasonably gift from this income in order to exemplify that it is surplus. This documentation will be essential for HMRC should your estate be reviewed.
• Demonstrate a pattern – Keep a record of spending patterns and recipients, as this information may need to be provided to HMRC as part of the Inheritance Tax return upon your death.
• Note the intention – Clearly state that gifts are made from surplus income rather than capital to strengthen your claim.

 

How can Butcher & Barlow assist?

Inheritance Tax planning can be complex, and without proper guidance, you may miss valuable opportunities to reduce your estate’s Inheritance Tax liability. At Butcher & Barlow, we specialise in providing tailored estate planning solutions, ensuring your assets are protected and your loved ones receive the maximum benefit.

For expert advice on estate planning, including making gifts out of surplus income, contact Benjamin Davenport-Lawton or your local Wills & Probate Solicitor today.

Click here to learn more about our Wills, Trusts & Estate Planning services.

 

 

 

The information in this article was correct at the time of publication. The information is for general guidance only. Laws and regulations may change, and the applicability of legal principles can vary based on individual circumstances. Therefore, this content should not be construed as legal advice. We recommend that you consult with a qualified legal professional to obtain advice tailored to your specific situation. For personalised guidance, please contact us directly.