Making gifts

Many individuals use gifts and trusts to help family members and carry out estate planning. However, the order that gifts are made can have serious tax consequences, especially when using trusts.

Ideally, gifting should be done as early as possible. This allows a gift longer to grow outside the estate, means the individual gifting is more likely to survive at least 7 years and provides more time for them to see the benefit of the gift for loved ones.

In practice, it is often later in life when gifting occurs. At younger ages, many will be less certain of how much they can afford to give away and estate planning may be less of a focus.

Treatment of gifts

Gifts that don’t fall into a specific exemption will normally be treated as a Potentially Exempt Transfer (PET) or Chargeable Lifetime Transfer (CLT) and will remain within the estate for 7 years.

A PET occurs where a non-exempt gift is made outright to an individual or to a fixed/bare trust (for the benefit of a named individual). These are ‘potentially exempt’ in that they attract no immediate tax charge and will not attract any Inheritance Tax (IHT) if the donor survives 7 years. 

However, on death within 7 years, a PET will fall into the estate and any amount that exceeds the deceased’s nil-rate band will become chargeable to IHT (reduced by taper relief if they survived at least 3 years).

CLTs typically occur where a gift is made to other types of trust, such as a discretionary trust. CLTs that exceed the settlor’s remaining nil-rate band are immediately chargeable to IHT in the member’s lifetime at 20% (half of the full IHT rate), with the remaining 20% payable if they die within 7 years of the gift (reduced by taper relief after 3 years).

The order to make gifts

The order in which gifts are made can have a large impact on the potential tax liability, especially when using trusts. Generally, the optimal way to make gifts and set up trusts would be as follows:

1. Wills – Having a valid and up to date Will should be most people’s priority. This ensures that assets in the estate go to the intended recipients on death and will be dealt with correctly.

2. Loan trusts – When looking to make non-exempt gifts or using trusts, a loan trust should be considered first. This involves making an interest free loan, so is not a transfer of value for IHT purposes. If set up before other gifts, a loan trust will benefit from a full nil rate band for periodic IHT charges (if discretionary) and making the loan will not impact any future gifts.

3. Exempt Gifts – Gifts that are fully exempt from IHT can actually be made at any time. However, we’ve placed after loan trusts, since the annual gift allowance is a useful way to regularly write off parts of an outstanding loan. Fully exempt gifts include:

• Gifts to a spouse/civil partner that fall within the spousal exemption.
  
• £3,000 annual allowance – the annual gift allowance (£6,000 if the previous tax year’s allowance is unused). 
  
• Small gifts and wedding allowances – £250 per person per tax year or between £1,000-£5,000 for weddings (depending on who is getting married).
  
• Normal expenditure out of income – ongoing gifts of excess income are immediately outside the estate if certain conditions are met.

4. Chargeable Lifetime Transfers (CLT) – Gifts to discretionary or interest in possession trusts (CLTs) would normally be made before potentially exempt transfers (PETs). If the settlor makes a PET before the CLT and then dies within 7 years, the failed PET will use up the nil rate band available to the trust. 

By ensuring any PETs are made after the CLT, they will not affect the nil rate band available to the trust, thereby reducing or avoiding the possibility of the trust incurring periodic or exit charges.

5. Potentially Exempt Transfers (PET) – A PET comes last on our gifting list. However, this is on condition that where an earlier CLT is made, the PET is either made in short succession to the CLT or at least 7 years after. This avoids the risk of up to £325,000 of the CLT (the value of the nil-rate band) remaining in the estate for up to 14 years – known as the ‘14-year rule’, as explained below:

If the 14-year rule is likely to be an issue, there will be circumstances where it is beneficial to make the PET before the CLT.

Comment

When looking to mitigate IHT, it can be tempting to make quick and easy gifts before carrying out more sophisticated trust planning. However, this can have unintended tax consequences for a future trust that is subject to periodic and exit charges.

Care is needed when carrying out estate planning and when looking at discretionary trusts, consideration should be given to whether further gifting is likely and whether the 14-year rule could become an issue.

We will cover the 14-year rule in more detail in a future update.

Important information

Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.