The following illustrative case studies demonstrate how making gifts out of income to use the normal expenditure out of income exemption can work in practice.
Case study one
Mr Blake, aged 55, has become increasingly concerned about the impact UK inheritance tax (IHT) would have on his estate when he dies. He earns around £150,000 each year, although this fluctuates depending upon bonus received. His annual performance bonus is due in May each year. His salary comfortably provides him with sufficient income to cover his standard of living.
Mr Blake has helped fund his three children through university and they have now all found employment. He and his wife are currently enjoying their re-found wealth. Whilst Mr Blake enjoys a large salary, over the last few years he has tended to spend this on material items. As a result, whilst still having a large estate, he does not have a substantial sum of freely available assets with which to carry out any IHT planning.
Mr Blake has discussed the IHT planning options available to him with his financial adviser.
A life assurance policy was considered as a way of funding the likely IHT bill, but as Mr Blake is still relatively young, he is unsure just how much cover he would require and doesn’t like the idea of paying premiums for what could be over 25 years. Instead, Mr Blake’s financial adviser recommends a single premium offshore bond, which allows additional premiums to be made at any time.
To make this offshore bond IHT efficient, Mr Blake must not have access to the offshore bond and so it is placed in a trust. As none of his children have any family yet, Mr Blake wishes to have some control over the future beneficiaries. Therefore, a discretionary trust with the settlor excluded (meaning Mr Blake, as the settlor, cannot benefit) is used.
Mr Blake’s performance bonus this year is £26,565. He therefore invests amount of £25,000 into the offshore bond that is written in trust. He records this amount as a gift made out of natural income for the tax year 2013/14.
Mr Blake receives a bonus of £52,455. He decides to use £50,000 of this sum to top up his offshore bond. Just like last year, he completes the supporting paperwork to show that this money has come from earned income and is not affecting his standard of living for the tax year 2014/15.
Unfortunately, bonuses this year have been low and Mr Blake’s only has an amount of £5,050 to invest in the offshore bond and reflect as a gift out of natural income for the tax year 2015/16. Whilst a relatively small amount Mr Blake adds a further £5,000 to his offshore bond so that it continues to be a regular and habitual payment made to the offshore bond.
Over the past three tax years Mr Blake has been able to invest a total of £80,000. This amount, together with any growth, is immediately outside his estate and therefore saving a potential 40% tax liability upon his death.
Case study two
Mr and Mrs Hill, aged 69 and 67 respectively, are both retired. Having stopped work early they have enjoyed a fairly active retirement with many holidays and new hobbies. Their spending has now settled down and they are finding that their regular expenses are lower than originally experienced.
Whilst they do not have a large amount of savings or any investments, they do have the benefit of substantial escalating pensions. They are now keen to find a way of immediately reducing the value of their estate for inheritance tax purposes. Unfortunately one of their two children is currently going through a difficult divorce so they want to maintain control over who will benefit. They meet with their financial adviser who recommends they each set up a regular premium investment. They decide to invest £300 each per month as they have consistently had more than this amount left for each of the last six months.
To ensure that the investments are tax efficient from an IHT point of view they are placed into discretionary trusts with the settlor excluded (meaning Mr and Mrs Hill, as the respective settlors, cannot benefit).
In order to provide an element of independence and privacy they have chosen to appoint an independent professional trustee, whose services they must pay for. Whilst relinquishing control of the trust’s assets, they are each able to provide the trustee with a ‘letter of wishes’.
This gives the trustee an indication of how they would prefer the trust’s assets to be dealt with. The letter is not binding on the trustee but provides them with some understanding as to the settlors’ intentions when they established the trust.
Mr and Mrs Hill complete both ‘gift letters’ and form IHT403 to ensure their paperwork is in good order.
Each year £7,200 plus any growth will build up in the trusts. The investments will be immediately outside of their estates, potentially saving £2,880 or more in inheritance tax each year.