August 2008

Guiding through the gifting process

When clients are thinking about estate planning, any gift of capital is one which requires careful thought. Capital gifts are often one-off and quite substantial. This however contrasts with the role which income gifts can play for clients. Income gifts can be smaller, more regular and therefore more manageable. Many clients may however be unaware of the inheritance tax (IHT) exemption which exists for normal expenditure from income, and therefore miss an opportunity to make the most of the statutory gift rules which exist.

An even stronger reason for financial advisers to be paying closer attention to income gifts is their role in advising on retirement income. While solicitors are often in a strong position to be making recommendations about capital gifting, in my experience it is often the financial adviser rather than the solicitor who holds the necessary information to be guiding a client through income gifting. This is because it is the financial adviser who is helping the client to assess their income needs in retirement.

Making the most of IHT exemptions

This article will assess how financial advisers can make more of this IHT exemption with their clients and will examine the all-important paperwork aspect to ensure the compliance elements are addressed at outset. There is no doubt that this is one area where financial advisers and solicitors can work closely together for the benefit of mutual clients. Financial advisers looking to develop their professional connections will be able to use this as a discussion point in working with local firms on this basis.

In understanding the IHT exemption for income gifts, the best starting point is in fact to work backwards and look at what reporting needs to take place for income gifts when the client dies.

This is the best guide for financial advisers to see what level of evidence is required to support a claim which will ultimately be made, perhaps many years later, by the executors of the deceased client. In most cases the compliance aspects only arise on death and the focus here is on the form D3A which can be found on www.hmrc.gov.uk. This is a one page form which is set out as a table. It requests information about the client's income and expenditure in a given year, then displays a final 'surplus income' box at the end which must be the net amount which the client can live off to maintain their normal standard of living. While this form is normally filed with HM Revenue and Customs on death, I would recommend there is no harm in completing this form in draft each year to gather the evidence on an ongoing basis. If no contemporary records are made, it is hugely time-consuming to reconstruct the picture of income and expenditure years later after the client has died. A copy of bank statements and any other relevant evidence of income and expenditure should be attached to a draft D3A to provide full supporting paperwork for the eventual claim. Ideally, these papers can then be stored with a client's will which is where the law firm liaison point arises.

As a refresher, the three criteria for the IHT income gift exemption are that:

1. the gift must be from income;

2. the gift must be 'normal', so that there is a pattern of gifting established or a clear intention of a future intention;

3. after making the gift, the client must have sufficient income left as surplus to maintain their normal standard of living.

What qualifies as a source of income?

There are a few points to be made about what qualifies as a source of income. Certain items must be disregarded since they are treated as capital and not income. For example, the tax deferred withdrawals from an investment bond are treated as capital, as is tax-free lump sum cash from a pension as well as the capital element of a purchased life annuity. Typical examples of income would be employment income, pension income, dividend income and bank interest as well as rental income.

I am often asked if clients can 'top up' their income by dipping into their capital to help qualify for this exemption. While of course clients can choose to do that, unfortunately that does not work for the purposes of establishing the IHT claim here, since the items of expenditure will still be shown on the D3A form but with no corresponding income source. The net effect is that the client cannot be shown to be able to live from their surplus income and so the claim fails. This standard of living point is also considered in relation to the particular client, so a client who takes modest holidays will need less of a surplus to live from compared to the client who takes regular cruises and has several houses to maintain, for example.

A question of circumstances

In terms of what counts as 'normal' expenditure, there is no set rule. It is all a question of the circumstances of the case, but clearly the ideal is for there to be an annual habit which has been formed over a period of years. Even better is a letter at outset from the client to the adviser/solicitor recording the gift as being made from income with the declared intention that it will be repeated in future. It is not necessary for the gift amount to be the same each time. Just as income can fluctuate, so the gift can fluctuate proportionately. In some cases, it might be possible to argue that just one gift in isolation qualifies for this exemption and that point was made in the Bennett case. This would probably require written evidence of intention together with the client's unexpected death. Clearly if the client was already seriously ill and unlikely to survive to make a further gift the following year, the claim would most probably fail.

A common example within financial services of this income gift exemption is the payment of premiums under a whole of life contract which is written in trust. By definition, it has the pattern of regularity about it which helps to establish one of the grounds for the claim. Another example could be regular increments to a bond in trust, such as a Gift Plan.

Since each case is considered on its own merits, there is no lower or upper limit as such for this exemption. This means it can apply to modest gifts as well as significant gifts. The key point is that the three criteria set out above are met. Other examples I have encountered in practice include a client who was the life tenant of a will trust. She had significant income from the trust which was not required to maintain her normal standard of living, so it was available to be gifted as part of this exemption. A further example is the employee in receipt of an annual bonus.

There are a few points to watch as flagged in the case of McDowall. In this case, pension income had built up in the current account of the client. The client was in a residential home and once the care fees were paid, almost by definition the client's standard of living was maintained. The gifts made in that case were documented and only failed due to a lack of power to make gifts in the power of attorney document. Since this was a Scottish case, the gifts would have been valid had the gift-making power been present. In England and Wales, the legal position is different and an application for approval of the gift would need to be made to the court.

All in all, the exemption for income gifts is flexible, underused and presents a great opportunity for advisers to work with their professional connections. Just keep a form D3A to hand as your best guide.

Julie Hutchison
Estate Planning Specialist
Standard Life