How Much Can You Gift IHT Free?

If you read my recent article on Tax Year End Planning [here] you may have noticed there was one set of tips that features in most other checklists that was deliberately missing from mine and that was those relating to Inheritance Tax [IHT].

For completeness I will include them here, before explaining why I think they are a nonsense being included in annual tax planning checklists in the same vein as maximising your ISA and pension allowances.

The Annual Exemption

Each tax year you can give away £3,000 free of IHT. If you did not use all the exemption in 2020/21, you can carry forward the unused element to this year (and no further), but it can only be used after you have used the current tax year’s exemption. For example, if you made no gifts in 2020/21, and you gift £4,000 in 2021/22, you will be treated as having used your full 2021/22 exemption and £1,000 from the previous tax year.

The Small Gifts Exemption

You can give up to £250 outright per tax year free of IHT to as many people as you wish, so long as they do not receive any part of the £3,000 exemption.

The Normal Expenditure Exemption

The normal expenditure exemption is potentially the most valuable of the yearly IHT exemptions. Under the exemption, any gift – regardless of size – escapes IHT provided that:

• You make it regularly;

• It is made from your income (including ISA income, but excluding investment bond and other capital withdrawals); and

• The sum gifted does not reduce your standard of living.

It is the Annual Exemption that frustrates me most.

The issue I have with this as a tax year end planning suggestion is that it has been trotted out so often, without any deeper explanation, that it has led to several widespread misconceptions which include:

• You can only gift £3,000 in a tax year free of tax

• Any gifts made above the £3,000 are subject to IHT…immediately

• The recipient pays tax (maybe even income tax) on any gifts received above £3,000

This causes parents and grandparents to hesitate making gifts, resulting in IHT liabilities increasing rather than decreasing.

What is “deliberately” missing from these tax planning articles is the mention of 7 years. Most probably because that would involve too much explaining, and there’s another 9 other tips that need to be squeezed into the same article.

The £3,000 rule should read, “if you die, any gifts you have made in the last 7 years of up to £3,000 per year, will not be subject to IHT”.

So that’s a maximum of £21,000 not subject to IHT…an £8,400 saving (assuming the current IHT rate of 40%).

Most people don’t have or want to gift £3,000 a year, and those that can or do, can probably utilise the gifts from normal expenditure rules.

Most people just want to make a one-off gift to their loved ones.

So here is new list of rules to replace the thinking above:

• There is no limit to the amount you can gift to an individual, ever.

• There is no tax payable at the point of this gift. No IHT on your estate and certainly no tax on the individual.

Keeping these new rules in mind, this should give most people the comfort they need to make gifts immediately without having to worry about tax.

Why Are Larger Gifts Not Immediately Taxable?

This is where the 7 year rule comes in, which most people are vaguely familiar with.

Gifts to most individuals are deemed Potentially Exempt Transfers [PETs] for IHT purposes. These are different from Exempt Transfers, such as transfers to your spouse or civil partner, charity or topically, a political party!

A PET is only chargeable if the transferor dies within seven years of making the transfer. A PET made seven years or more before death is an exempt transfer for IHT purposes.

PETs are also assumed to be exempt at the time of transfer, and as a result no IHT is payable at that time.

A PET is only chargeable if the transferor dies within seven years of making the transfer. A PET made seven years or more before death is an exempt transfer.

So to summarise where we are so far. If you want to make a gift to someone, you (and they) have no immediate tax concerns. You can gift as much as you like to whomever you like.

What Happens If Death Does Occur Within 7 Years?

Well, in most circumstances, nothing. So long as cumulative gifts within the 7 years prior to death are less than the Nil Rate Band (currently £325,000), then no tax will be due on those gifts.

This is because gifts made in the previous 7 years use up an individual’s Nil Rate Band first, before their estate on death is included in any calculation.

Here’s an example to illustrate.

John made the following transfers (after exemptions and reliefs):

£50,000 to his son, James, in August 2020

£50,000 to his daughter, Sara, in February 2021

John dies with a death estate of £525,000 in February 2022 when the NRB is £325,000.

The gift to James becomes a chargeable transfer and absorbs £50,000 of the NRB at date of death. No tax will be due on the failed PET as it falls within the NRB.

The gift to Sara also becomes a chargeable transfer and absorbs a further £50,000 of the remaining NRB of £275,000. Again, no tax will be due on the failed PET as it too falls within the overall NRB.

This leaves John’s estate with a Nil Rate Band of £225,000 and an IHT bill of £120,000.

The IHT position on John’s estate is the same both ways. Had he not made the gifts, his estate would be £625,000, his Nil Rate Band would have remained intact at £325,000 and the IHT bill would be £120,000.

I have ignored here the Residence Nil Rate Band which we will consider in a later article.

This however is no reason not to make the gift. In fact you could argue it is more reason to as doing nothing guarantees the value remains in your estate and potentially grows, if for example, the gift was made from investments.

What Happens If Transfers Have Exceeded The Nil Rate Band?

Let’s change the example above slightly.

Joan made the following transfers (after exemptions and reliefs):

£170,000 to her son, David, in August 2020

£170,000 to her daughter, Claire, in February 2021

Joan dies with a death estate of £225,000 in February 2022 when the NRB is £325,000.

The gift to David becomes a chargeable transfer and absorbs £170,000 of the NRB at date of death. No tax will be due on the failed PET.

The gift to Claire will use up the remaining NRB of £155,000 meaning that the excess of £15,000 becomes chargeable in its own right and is cumulated with the death estate to calculate the IHT payable. IHT is charged on the cumulative total of £240,000.

Claire is primarily liable for the IHT due on the failed PET, £6,000. Joan’s estate is liable for IHT on the £225,000, some £90,000.

As we can see, only once cumulative transfers exceed the Nil Rate Band is there a real potential for the gifts to be taxable. Most gifts are well below these levels. Couples can plan effectively by gifting £650,000 between them…although if one spouse has a greater life expectancy it may make sense to make a larger gift from them.

The above are an overly simple explanations and do not cover gifts into discretionary trusts which have their own set of rules. Nor do they cover gifts with reservation.

Conclusion

Inheritance tax is the easiest tax to avoid, however there are numerous pitfalls.

If you want to make a gift and are in any doubt over the tax situation then please speak with me. Also, look out for the upcoming article on gifting to children for property deposits.

For the avoidance of doubt, an "individual" is a human being and "individual" would not therefore include a corporation or company. If you are making the gift to a trust, there is a limit, £325,000. Anything more than that would be taxable at 20%.

Footnote on taper relief?

Some people are aware that the tax liability on PETs reduces throughout the 7 years.

To start with, although its called taper ‘relief’, it is not strictly a relief. Its actually a percentage reduction in the tax payable.

Taper relief (under IHTA/S7(4)) applies where:

• the gift was made more than three years but less than seven years before the transferor’s death, and

• tax is due on the gift in its own right.

This is the key point, it does not reduce the capital value of the gift – it only reduces the actual tax payable. Therefore, if there is no tax payable on death on a specific gift, you cannot claim taper relief to reduce the value of that gift.

Consequently, any gift which sits inside the available NRB cannot benefit from taper relief. Which will cover the vast majority of gifts.

In our examples above, there is no taper on the gifts to James and Sara, and John’s estate is still reduced by the full £100,000 gifts. In the second example, only the £15,000 excess of the gift to Claire would potentially benefit from the taper, but only from February 2024 onwards.

The sliding scale is as follows:

So if Joan had survived and dies in say, March 2028 (assuming no rules changes), the taper rate would be 40% and Claire would pay £3,600 on the gift instead of the £6,000.