Question: How can I reduce my estate for inheritance tax purposes when all my capital is tied up?
Answer: One the most effective forms of IHT planning, for those who can afford it, is making lifetime gifts of capital. But what can be done when a sizeable chargeable estate is incapable of being transferred because of other tax, commercial or practical reasons?
An individual in this situation, having already made use of the annual and small gift exemptions, might be limited to making occasional gifts of unused income and then hope to survive the dates of making the gifts by seven years so that the values of the gifts fall out of the estate at death for IHT purposes. Such an individual might be able to improve the position by arranging affairs so that the exemption for “normal expenditure out of income” can be claimed on death. If the claim is successful, any such expenditure is ignored when considering gifts made in the seven years prior to death.
In order to qualify, the expenditure must be normal or habitual, it must (taking one year with another) be made out of income and after making all such transfers of value the individual must be able to demonstrate there has been no drop in the usual standard of living.
Whether or not a pattern of expenditure is habitual is largely a question of fact but certain steps, such as setting up standing order arrangements or instructing trustees to pay trust income elsewhere, may be very helpful, especially if the individual concerned dies before a regular pattern has been established.
In order to help determine whether the second and third conditions have been met, HM Revenue & Customs now expect large amounts of detail of income and expenditure of the years preceding death to be entered on Form IHT 403. Income includes both taxable and non-taxable income from all sources less any income tax paid.
Expenses include amounts which should be fairly easily determined, such as mortgage payments, utility bills, insurance premiums, nursing home fees, but also include items the personal representatives perhaps cannot easily determine such as travel, holidays, entertainment, birthday and Xmas presents. The surplus of income over expenditure is then compared with the value of gifts for which the exemption is being claimed in order to determine whether the gifts were indeed made out of income rather than capital.
So it seems fairly clear that an individual who hopes for the estate to benefit from this exemption might be well advised to keep orderly and complete records to ensure the personal representatives have the best possible chance of success and do not inadvertently submit an incorrect claim for exemption.
Ben Chaplin is managing director of Croner Taxwise
