Timing and Inheritance Tax: what should I consider before making a lifetime gift?

Inheritance Tax applies primarily on death but also to gifts made within 7 years of death, subject to any applicable exemptions and reliefs. It is therefore important for an individual to consider what implications gifts made during their lifetime may have for inheritance tax purposes.

However, everyone is entitled to benefit from the nil-rate band. For the tax year 2019-20 the nil-rate band allows an individual to pass on assets in their estate up to the sum of £325,000 free of tax. Anything which exceeds this threshold is then charged at 40%. The nil-rate band is transferable between spouses and civil partners, meaning that if an individual does not use their full nil-rate band on their death, any remainder can be transferred for the benefit of their spouse or civil partner’s estate. Under this principle, an estate can benefit from a nil-rate band of up to £650,000.

Therefore, in reality, very few people are within the scope of Inheritance tax and it accounts for less than 1% of taxes in the UK. However, it can still be a worrying and complex concept.

Timing a lifetime gift

There are many considerations to take into account before making a lifetime gift, that affect which assets to gift, how to gift it and how much should be gifted to another individual. One such consideration is the timing of the gift.

How an individual approaches inheritance tax planning will vary over their lifetime. For instance, younger clients may want to reserve capitals assets (such as their home, car, jewellery or shares) and maximise their income to cover their living expenses. Where an individual has surplus income, they may make use of the normal expenditure out of income exemption (see below).

For older clients, preserving capital will become less relevant depending on their needs and life-expectancy.  
No matter when the transfer takes place, an individual must be careful to consider their own immediate needs and financial position as well as anticipating any future requirements they may have. In this sense, timing remains important throughout a person’s lifetime.

Potentially exempt status: The 7 year rule

Timing is of particular importance in relation to inheritance tax consequences of lifetime gifting. If no exemption applies, a gift is considered ‘potentially exempt’. This is because at the time of the transfer no inheritance tax is chargeable. The gift only becomes chargeable should the transferor die within 7 years following the transfer. Should they survive this period, the transfer becomes fully exempt.

Where potentially exempt transfers become chargeable – i.e. where the transferor dies within 7 years of making a gift – taper relief may apply. This relief works to reduce the tax payable on gifts made within 3 to 7 years of an individual’s death. The tax on gifts is tapered on a sliding scale, the currents rates set out below: 

Years between gift and death	Tax payable
Up to 3 years	40%
More than 3 years	32%
More than 4 years	24%
More than 5 years	16%
More than 6 years	8%
7 or more years	0%

It is important to note that taper relief is limited to reducing the amount of tax payable on a gift; the gift itself is not tapered. It follows that if the tax is not payable on a gift for any reason (for instance, if the gift falls under a recognised exemption or is within the nil-rate band), taper relief will have no effect.

What are the exemptions?

As will become clear, whether an exemption applies to determine whether or not inheritance tax is chargeable depends on a number of factors:

• The timing of the gift: whether it is a lifetime gift or a transfer on death
• The recipient of the gift
• What is transferred
• Why it has been transferred

Exemptions on death and lifetime transfers

Spouse or civil partner exemption

Any transfer of assets is exempt if it passes to the transferor’s spouse or civil partner whether during the transferor’s lifetime or upon death, under the deceased’s will or intestacy. The exemption also applies in the case of joint property, where the asset passes by survivorship.

At present, this exemption does not extend to cohabitees. The Office of Tax Simplification (OTS) has commented in its most recent report that that any extension of the exemption to include cohabitees would be for the government to decide.

Charity exemption

Any property which passes to a charity whether made within the transferor’s lifetime or on death is an exempt gift for inheritance tax purposes. This exemption applies regardless of its value and however it is made (i.e. as an outright gift or into trust).

In order for the exemption to apply, the recipient must satisfy the definition of ‘charity’, namely is a body of persons or trust established for charitable purposes only.

Other exempt bodies include transfers for national purposes, to political parties, to housing associations and to maintenance funds. 

Exemptions only on lifetime gifts

Annual exemption

This exemption applies to the first £3,000 transferred by lifetime transfer(s) in each tax year. Any unused annual exemption may be carried forward for one year only, so a maximum exemption of £6,000 may be available. However, the current tax year’s annual exemption must be applied first and therefore the carried-forward exemption might remain unused.

The timing of the transfer is key in determining how this exemption will apply. If more than one transfer is made within any one tax year, the exemption is used to reduce the first transfer. Any unused exemption is then set against the second and any further transfers until it is used up.

Small gifts

In any one tax year gifts by the transferor of up to £250 per recipient are exempt. Should the transferor gift in excess of £250, by one or an accumulation of gifts, the exemption shall not apply in regards to that recipient.

In addition, the exemption extends only to outright gifts and therefore does not apply to transfers made into trusts. It also cannot be combined with any other exemption for lifetime gifts, such as a gift on marriage (see below).

Normal expenditure out of income

A lifetime transfer may be exempt where it is a gift out of surplus income. In order for the exemption to apply, the following conditions must be met:  

• It was made as part of the transferor’s normal expenditure
• It was made out of the transferor’s income
• After allowing for all such payments, the transferor was left with sufficient income to maintain their usual standard of living

Where an individual seeks to make use of this exemption, it is advised that they keep detailed records of their income and expenditure as well as any gifts they make. This can ensure that upon death there is sufficient evidence for the exemption to apply.

Gifts in consideration of marriage

Lifetime gifts, including those into a trust, for the benefit of a couple entering into marriage or a civil partnership are exempt up to the following amounts:

• £5,000 by a parent of a party to the marriage/civil partnership
• £2,500 by a grandparent or remoter ancestor of a party to the marriage of civil partnership 
• £1,000 by anyone else

Importantly, these amounts cannot be set against larger gifts to reduce the overall amount charged to inheritance tax.

How the exemptions work

If an exemption is applicable to a gift or transfer, it will work to exempt the whole transfer from attracting inheritance tax. In the event that an exemption does not apply, other reliefs are available which work to exempt the whole or part of the transfer, including business property relief and agricultural relief.

It is advised that, when seeking to rely on any exemption or relief, records are kept of any gifts made, to aid the personal representatives in administering the estate.

The residence nil- rate band

An estate may also benefit from an additional nil-rate band which applies specifically to residences. Subject to qualifying provisions, a residence nil-rate band (RNRB) is available to estates where the main residence is ‘closely inherited’.

This essentially means that where an individual gives away their home to children or grandchildren upon their death (including adopted, foster and step-children), they may qualify for the RNRB and benefit from an additional threshold of a further:

Tax year	Additional threshold
2017–18	£100,000
2018–19	£125,000
2019–20	£150,000
2020–21	£175,000

 Therefore, where a death occurs in 2019-20, the total nil-rate band available would be £475,000, comprising of the basic nil-rate band of £325,000 and an additional RNRB of £150,000.

Points to note:

• The RNRB may still be available where an individual has downsized or sold their main residence to move into residential care, subject to conditions.
• The RNRB is tapered where the value of an estate is in excess of £2 million. 
• Similarly to the basic nil-rate band, any unused RNRB is transferable between spouses and civil partners. 

Comment

One of the main ways individuals minimise the future inheritance tax charge on death is achieved by lifetime gifting to reduce the value of the estate owned on death.

The most appropriate way to approach inheritance tax planning will vary depending on a number of circumstances, including timing. Therefore it is advised that before making a significant gift you should consider seeking legal and/or financial advice. Remember, any lifetime planning needs to be reviewed regularly to ensure it remains suitable in relation to changes in your circumstances and in taxation.

The OTS, as the Government’s independent tax advisor, aims to alleviate the complexity of lifetime planning by suggesting recommendations to make the design of Inheritance Tax easier to navigate. In view of the upcoming general election, it will be interesting to see how far its recent recommendations are implemented in the months to come, if at all.