Every individual can make lifetime gifts which are exempt from Inheritance Tax (IHT), regardless of how long passes between the gift and the date of death. The exemptions are:

• Maintenance of a spouse or children
• Normal expenditure out of income
• Small gifts to any one person
• Wedding gifts
• Annual exemption

Dealing with each of these points in turn:

• Maintenance of a spouse or children

Maintenance payments are not actually gifts at all, but are funds spent on others. Given that lifetime gifts to a spouse are IHT exempt in any event, this exemption mainly covers payments to a former spouse made in accordance with the terms of a divorce settlement. Payments for the maintenance of children are only exempt if the child can receive benefits whilst a minor, or whilst an adult but in full time education.

• Normal expenditure out of income

Gifts of any amount are exempt if they form part of normal expenditure out of income (that is, they are not gifts out of capital), and leave the individual with sufficient income to maintain their usual standard of living. “Normal” means normal for the individual and not the average person. A regular pattern of giving is required.

Generally speaking, the exemption is claimed in the event of the individual’s death, and so detailed records of the gifts need to be kept during the individual’s lifetime. This can be achieved by the individual inserting details of each gift in the specific form that needs to be submitted to the tax office on death. The exemption can be used to make regular gifts into a savings account or a life policy written in trust.

• Small gifts to any one person

Gifts of up to £250 to any one person during a tax year are exempt. There is no limit to the number of persons who can benefit, but the gift cannot be combined with any other gift (such as a wedding gift or the annual exempt amount).

• Wedding gifts

Gifts on the occasion of a marriage are exempt up to certain limits, which depend on the relationship of the individual to the person receiving the gift, as follows:

• Each parent can give £5,000
• Each grandparent (or great-grandparent) can give £2,500
• Anyone else can give £1,000
• Annual exemption

Any other gifts are exempt up to £3,000 a year. If the annual exemption is unused for a particular tax year, the unused portion may be carried forward for one tax year only.

Any gift which does not fall within one of the above exemptions is a potentially exempt transfer (PET). A PET is “potentially” exempt because if the individual survives for seven years from the date of the gift, the gift becomes fully exempt. If the individual fails to survive for seven years, the gift will use up all or part of the individual’s nil rate band on death. Taper relief will begin to reduce any IHT due on the gift after only three years, which means that there is no taper relief for gifts that do not exceed the nil rate band.

Lifetime gifts are an important IHT planning option but the following points should be considered first:

• Gifts made on behalf of a mentally incapable individual
• Gift with Reservation of Benefit (GROB) rules
• Capital Gains Tax (CGT)
• Control of the asset given away
• Access to the asset given away

Dealing with each of these points in turn:

• Gifts made on behalf of a mentally incapable individual

An Attorney (or Court appointed Deputy) can only make gifts to people who are related to or connected with the mentally incapable individual; and then only on customary occasions such as birthdays, weddings, anniversaries, Christmas or other religious holidays, when the mentally incapable individual would have usually given gifts; and then the value of any gift must be reasonable having regard to all the circumstances and, in particular, the size of the mentally incapable individual’s estate. What is “reasonable” will depend on the mentally incapable individual’s circumstances.

The Attorney / Deputy will need to make a formal application to the Court of Protection for permission to make gifts that are not considered customary, or “reasonable”, which includes gifts for IHT planning purposes.

Where Court of Protection approval is not sought, or given, for a gift then the gift will be invalid. From an IHT perspective, this means that the tax office will treat the individual’s estate as if the gifts had never been made.

• Gift with Reservation of Benefit (GROB) rules

A gift forms part of the individual’s taxable estate for seven years from the date of the gift. However, if a significant benefit in or enjoyment of the asset given away is retained, it will remain part of the taxable estate on death regardless of how long ago the gift was made. These gifts are called GROBs.

The GROB rules mean that it is not acceptable for the individual, or the individual’s spouse, to be a beneficiary of a trust which has received assets by way of gift (whether or not they actually benefit from the trust assets).

• Capital Gains Tax (CGT)

Depending upon the nature of the asset, an immediate CGT charge may arise on disposing of an asset if its value has increased since it was acquired. Disposing of an asset could mean a sale or a gift. Acquired could mean purchased, or inherited, or received by way of gift.

Where there is a potential CGT charge on a gift, hold-over relief may be available – such as for gifts of business assets or agricultural land – on which expert advice is available. In essence, the chargeable gain is not taxed when the gift is made but is “held over” (that is, passed on) to the recipient of the gift, who pays the CGT when they dispose of the asset.

• Control of the asset given away

Control of the subject matter of the gift is lost once it has been given away. This could be a problem if any beneficiary of the gift were, for example, not yet an adult, to divorce, die, be made bankrupt, or receive means-tested benefits. One solution is to contribute to a pension scheme for the chosen beneficiaries. Another solution is to set up a trust for the chosen beneficiaries, and transfer the asset to be given away to the trustees:

Trusts

A trust is also called a settlement. The individual who creates the trust is the settlor, and states in the trust deed how the trustees should use the trust fund for the beneficiaries.

The trustees are the custodians of the trust fund and must deal with it as set out in the trust deed. Trustees must act unanimously, and so just one trustee can prevent payments from the trust fund even if all the others agree. Choice of trustees is therefore crucial. The settlor can be a trustee.

The beneficiaries are those who benefit from the trust fund, and are either specifically named or defined as a group such as “the children of the settlor”. Different beneficiaries can benefit from the trust fund in different ways.

The trust fund will be anything that is put into the trust by the settlor, and thereafter will be anything in which the trustees invest, such as cash, investments or property.

The term of the trust can be up to 125 years (unless it is a charitable trust which can continue forever). The trust need not continue for this length of time – and will typically end much sooner – but it cannot last for longer than this period.

Different types of trust include:

A bare trust is one where the beneficiaries are specified and cannot be changed. A beneficiary of a bare trust can demand their share of the trust fund once they are an adult.

An interest in possession trust or life interest trust is one where the beneficiary (known as the life tenant) has no right to the trust capital, but instead has an immediate right to the trust income (after tax and expenses) as it arises, or to occupy any trust property (whether or not it produces income) without the trustees having to make any further decision to confer such a right. On the death of the life tenant, the trust capital passes to other beneficiaries (known as the remaindermen). With an interest in possession trust, the trustees may have a “power of appointment”, which means they can, if they wish, pass part or all of the trust capital to any of the beneficiaries (whether the life tenant, the remaindermen, or otherwise).

A discretionary trust generally has a widely defined group of beneficiaries, and is one where no beneficiary has a right to income or capital from the trust fund. Instead, as the name suggests, the trustees have the discretion to decide how much income or capital (if any) to pay to each of the beneficiaries. Whilst it is possible to guide the trustees on how to exercise their discretion by preparing a Letter of Wishes, the ultimate decision on how (or even whether or not) to exercise their discretion rests with the trustees. Discretionary trusts are a way of maintaining some control over the trust fund to cater for changes in circumstances of beneficiaries such as divorce or bankruptcy or simply age of inheritance.

The taxes that apply to trusts include:

• Inheritance Tax (IHT)
• Capital Gains Tax (CGT)
• Income tax

An IHT charge can arise:

• When assets are given to the trust (the entry charge). The entry charge is 20% of any gift above the available nil rate band. If the settlor fails to survive seven years from the gift to the trust, further IHT may be due.
• On every ten year anniversary of the creation of the trust (the anniversary charge). The anniversary charge arises ten years after the trust was created, and on each subsequent ten year anniversary. The trust fund (including any payments made from it) is valued, and any sum in excess of the then nil rate band is taxed at a maximum rate of 6%.
• When capital is distributed to beneficiaries (the exit charge). The exit charge arises on any distribution of trust assets between each ten year anniversary, and is based on a number of factors including the value of the assets being distributed. The maximum rate of tax applied is 5.85%.

A CGT charge can arise on capital gains made on a disposal of chargeable assets. A disposal may be:

• An actual disposal, for example when trustees sell or transfer an asset
• A deemed disposal, for example when a beneficiary becomes absolutely entitled to an asset

The CGT rate applicable to trusts is 28%, with half the personal allowance that is available to an individual. Where a potential CGT charge on an actual disposal to a beneficiary is identified, hold-over relief may be available to defer this.

An income tax charge can arise on income arising from trust assets, such as dividends from shares, interest on cash and rent from property. The trustees are usually liable to pay income tax during the lifetime of a trust.

The income tax rate applicable to trusts is 45%, with no personal allowance available. The beneficiaries may pay tax on any income they receive from the trust at their tax rates, with credit for tax paid by the trustees.

This general information will not apply to every trust. For example, special rules apply to trusts which have business or agricultural property, or are for disabled beneficiaries, or were set up before 22 March 2006. Expert advice is available.

As stated above, where the assets to pass into trust are in excess of the prevailing nil rate band then an IHT entry charge will be payable, and potentially anniversary and exit charges, and so in such circumstances a partnership or company structure can be considered as an alternative option.

Family Limited Partnership (FLP)

A family partnership is a business where the partners are members of the same family. A family partnership structured as a limited partnership (that is, a Family Limited Partnership (FLP)) is where a general partner (GP) has unlimited liability for the debts of the partnership, and is the only partner who can manage the partnership; and the limited partners have limited liability for the debts of the partnership, and cannot take part in management of the partnership. The GP may be a limited company so as to achieve limited liability.

The individual passes assets to the FLP, and retains full ownership of the GP company, and also a limited partnership interest. The individual then gives limited partnership interests to their chosen beneficiaries, and gradually transfers ownership and ultimately control to the next generation.

There is no IHT entry, anniversary or exit charges with an FLP. However, an FLP is classed as a collective investment scheme (CIS) by the Financial Services and Markets Act 2000, and so certain management functions must be carried out by persons authorised by the Financial Conduct Authority (FCA). The costs associated with this mean that the FLP would need assets of many millions to make it worthwhile.

Family Investment Company (FIC)

An FIC is a private company whose shareholders are all members of the same family. There is no requirement for an FIC to operate a business as with a partnership, and so it can hold investments such as shares or land. Further, an FIC is not a CIS and so will not involve an FCA authorised person.

The directors retain day-to-day control of the FIC and decide how the assets should be invested. The individual who sets up the FIC can be one of the directors. Whilst the appointment of new directors is decided by the shareholders, unanimous approval can be required for this, and so the individual can retain control by holding a nominal number of shares.

An FIC allows a number of classes of shares to be issued, with different rights attaching to those shares. This allows control (in the form of ordinary shares with voting rights) to be separated from value (in the form of non-voting ordinary shares) which enables value to be passed on, whilst retaining control of the company. A share class can be created into which future growth in the value of the FIC passes, and these shares can be given to a trust or family members and fall outside of the individual’s taxable estate after seven years.

There is no IHT entry, anniversary or exit charges during the life of an FIC. If the individual holds shares on death, they will form part of the taxable estate but the market valuation of the shareholding is likely to be discounted from the true asset value to reflect its size (for example, a minority shareholding can attract a significant discount).

• Access to the asset given away.

Only those who can afford to make outright gifts should consider doing so. If access to the funds to be given away may be needed then the following arrangements, which are not considered to be GROBs, should be considered instead.

Gift & Loan Trust (G&LT)

With a G&LT, the individual sets up a trust, and makes a small gift to that trust followed by an interest-free loan to the trustees. The individual has the right to receive repayment of the loan, but is otherwise excluded from benefiting from the trust in any way. The amount of the loan is typically invested by the trustees in an investment bond.

The loan to the trustees remains within the individual’s taxable estate (even after seven years) and so achieves no reduction in IHT. However, the G&LT helps avoid an IHT liability increasing because any growth in the value of the investment falls outside of the taxable estate.

The individual can have the loan repaid in instalments or lump sums at any time. Once the loan has been fully repaid, the individual has no further entitlement to the funds held in trust which are paid to the beneficiaries after the individual has died. If the loan has been fully repaid, and subsequently spent or given away, the original capital will have been removed from the individual’s estate for IHT purposes.

Discounted Gift Trust (DGT)

A DGT generally involves the individual setting up a trust, and making a gift to that trust whilst retaining the right to a life-long income from the lump sum given away. The amount given to the trust is typically invested by the trustees in an investment bond.

The trust creates two separate rights (although there are not, in fact, two separate funds):

• “The applicant’s fund” or “the settlor’s fund”: the individual’s right to regular payments of a specified amount out of the capital of the trust fund for life (or until the trust fund is exhausted)
• “The beneficiaries’ fund” or “the residual fund”: the trustees’ right to whatever is left in the trust fund on the individual’s death, including any investment growth, which they hold on behalf of the beneficiaries of the trust

If the individual were to die within seven years of establishing the DGT then the amount of the gift is the full amount of the initial investment less a discount equal to the open market value of the regular payments which are due to be repaid during the individual’s expected lifetime. The amount of IHT in the estate could be reduced as a result of the discount.

The current open market value of the individual’s right to regular payments is calculated with reference to the amount and frequency of payments selected, and on how many of those payments the individual could expect to receive over their lifetime. It is therefore necessary for the individual to complete a statement of health; a GP’s report is requested; and a medical examination may also be requested.

There are some points to be aware of in relation to a DGT:

• A DGT is generally not suitable for those who do not require “income”, since if the regular payments are not spent then the funds will accumulate within the individual’s taxable estate
• The regular payments cannot be amended (whether increased, reduced or stopped)
• Some DGTs do not allow monies to be paid to the beneficiaries during the individual’s lifetime
• After seven years, the value of any gift falls outside of the taxable estate and so the discount becomes irrelevant
• If the individual survives for the expected life expectancy then the “income” received will negate the effect of the discount. Those who die prior to the assumed life expectancy will therefore gain the most from a DGT

The discount can be challenged if insufficient or incorrect medical evidence was collected when setting up the plan, or if the life company has calculated a discount using a method which differs from the tax office’s published approach.

Flexible Reversionary Trust (FRT)

A FRT generally involves the individual setting up a trust, and making a gift to that trust whilst retaining the right to the maturity proceeds of a series of investment bonds in which the trustees invest. The investment bonds mature in consecutive years, but the trustees have the power to defer the maturity dates which allows the “income” to be tailored to the individual’s requirements, including no income at all.

The ability of the trustees to defeat the maturities, and deny the individual any income, means that the value of any retained rights under these arrangements should be negligible. Whilst there is no “discount” on the gift should the individual die within seven years of establishing the FRT, if the individual survives for seven years, IHT will be avoided on the whole trust fund.