How to avoid inheritance tax legally and save income

You can avoid inheritance tax legally and save on your estate by giving family or friends your excess income. But if your earnings take a dive one year, how can you ensure maximum tax efficiency for this arrangement?

Knock-on effect

The recession has caused many people’s income, whether in the form of earnings from a job or investments, to drop over the last few years. That’s bad news in itself but it can have an unexpected knock-on tax effect. If you were relying on the so-called “gifts out of income” inheritance tax (IHT) exemption, your lower income could create another problem for you.

How much is exempt?

S.21 of the Inheritance Taxes Act 1984 says that if you make a gift out of your income, no matter how great, it will cease to be part of your estate for IHT purposes from the moment you make it. That’s good news, as usually you’ll have to wait for seven years before a gift becomes IHT exempt. That makes “s.21 relief” a really useful tax planning tool for keeping the level of your estate down. But it’s not all plain sailing.

Conditions recap

As you would expect, HMRC throws in a few conditions. Apart from needing to be paid out of your net income:

• First condition. The gift should be part of your “normal expenditure”. “Normal” in this case means usual and expected.

Trap. If you don’t make the gifts on a regular basis, say, once a year, the exemption won’t apply.

• Second condition. After making the gifts you must have enough income left to maintain your usual standard of living. But there are exceptions to this condition. If your available income is less because of unexpected expenses, e.g. short-term nursing care costs, these can be ignored.

The best laid plans

Say that several years back as part of your IHT plan you started to make regular gifts to your grandchildren. But your income has dropped to a level where you’re having to eat into your capital to make the gifts. This will mean that they could lose their exempt status and potentially be liable to 40% IHT. What action should you take?

Not in isolation

Firstly, don’t panic into stopping the gifts, as you may be OK if your income recovers to a level where it will again cover them. The law says that you can “take one year with another” when considering whether you have enough income. For example, even if your income wasn’t sufficient in 2013/14, as long as your 2014/15 income will be enough to cover the shortfall, and any gifts out of income for 2014/15, the exemption can still apply for both years.

Tip. Record keeping is vital to prove that s.21 relief applies. You’ll need to be thorough in listing all your income, expenses and gifts each year.

Advice from the horse’s mouth

HMRC’s guidance at IHTM14250 says that if a gift is paid out of a current account, it will accept it as a gift out of income, no questions asked.

Tip. Pass all cash gifts via your current account and keep a copy of the relevant bank statement with your spreadsheet.