When passing accumulated wealth to future generations it is essential to consider the order in which gifts are made as gifting in the wrong order can have serious tax consequences. Sometimes there may be little an adviser can do about this if an individual has already made gifts without advice.
Getting the order of gifting wrong can be costly but getting it right could save a massive amount in inheritance tax (IHT). So in this article we aim to highlight the pitfalls that should be avoided and the order that gifts should be made in.
There are two key points to pick out that will impact on the order of gifting.
First, chargeable lifetime transfers (CLTs). CLTs are commonly gifts to relevant property trusts, such as discretionary trusts, flexible trusts since March 2006 and so on. When making a CLT, any other CLTs made in the seven years before will reduce the available nil-rate band and have a direct impact on the ten-year periodic charge and exit charge calculations.
Simplistically, a periodic charge of 6% applies where the value of the trust plus the distributions to the beneficiaries in the previous ten years is greater than the available nil rate band. The nil rate band in this case is the nil rate band on the tenth anniversary, less any CLTs made in the seven years before the trust was created. The tax applies to the excess.
- In January 2013 Lisa set up a discretionary trust with a gift of £200,000, this is Trust A. Lisa regularly used her £3,000 annual gift exemption and had made no previous CLTs.
- As the gift is below the available nil rate band of £325,000 no tax is payable.
- In January 2017 Lisa sets up another discretionary trust, Trust B, with a gift of £125,000. Once again she has used her £3,000 annual gift exemption.
- When calculating whether tax is payable on the CLT in 2017 any CLT made in the previous seven years reduces the available nil-rate band.
- The available nil-rate band to use against the 2017 CLT is £125,000.
- In this situation both CLTs are equal to the available nil-rate band and no tax is payable.
- In January 2023, Trust A reaches its tenth anniversary and there is a periodic charge calculation required. The trust has grown to £330,000 and the nil rate band to £340,000.
- As there have not been any distributions to the beneficiaries during the last ten years and the value of the trust is within the available nil rate band, there is no periodic charge.
- In January 2027 the trustees must calculate whether a ten-year periodic charge is due on Trust B. The trust value has grown to £250,000 and the nil rate band has increased to £350,000
- As the value is lower than the nil rate band no tax is payable – wrong!
- As the CLT made in January 2013 was within seven years of the CLT in 2017, the available nil rate band at the ten yearly anniversary for Trust B is reduced to £150,000 (£350,000 – £200,000).
- Therefore the periodic charge payable for Trust B will be 6% x (£250,000-£150,000) = £6,000.
- Exit charges would therefore apply for the next ten years on any money paid out of Trust B to the beneficiaries and the reduced nil rate band will apply on each tenth anniversary.
For this reason clients should consider previous CLTs made within the last seven years when making further CLTs.
The second key point centres around potentially exempt transfers (PETs). If a person dies within seven years of making a PET, the PET fails and is treated as a chargeable transfer. This means that if a PET is made before a CLT and it subsequently fails, it will be brought into account for the purposes of the ten-year periodic charge on the CLT.
- In January 2013 Maura made an outright gift of £400,000 to her daughter. As this is a PET no tax is payable
- In January 2017 Maura sets up a discretionary trust with a gift of £200,000. Maura regularly used her £3,000 annual gift exemption and so the whole amount is a CLT.
- As the gift is below the available nil rate band no entry IHT is payable
- Maura, sadly, dies in January 2019. As there was a transferrable nil rate band available to her there was no IHT to pay on these gifts
- In January 2027 the trustees of the discretionary trust must calculate whether a periodic charge is due. The trust value has grown to £250,000 and the nil rate band has increased to £350,000
- Again it is wrong to think that no tax is payable as the value is lower than the nil rate band
- As Maura died within seven years of the PET, the PET failed and became chargeable. As the failed PET was £400,000 the available nil rate band at the ten-yearly anniversary (2027) is zero, having been completely used up by the PET.
- Therefore a periodic charge will be payable in 2027 on the trust of 6% x £250,000 = £15,000.
- Exit charges would therefore apply for the next ten years on any money paid out to the beneficiaries.
- On each tenth anniversary the nil rate band for the discretionary trust will be zero and therefore periodic and exit charges will continue to apply.
Both examples illustrate that the order of gifting is of paramount importance in estate planning and needs to be undertaken in the correct order.
The suggested order (with at least one day between each structure), where a number of solutions are being considered to solve a specific IHT situation is as follows:
1. Loan Trusts
The loan to the trustees is not a transfer of value (and so does not impact on subsequent arrangements), but if the trust is discretionary there may be potential periodic and exit charges if the growth in the trust is sufficient.
For large loans it may be beneficial to spread the amount over multiple gift and loan trusts.
As there is no transfer of value, on each tenth anniversary a discretionary trust version will have a full nil rate band available to it, providing that there were no additional arrangements set up on the same day. Therefore having two gift and loan trusts set up on consecutive days would allow the trustees of each to potentially have a full nil rate band for each trust, thereby reducing the possibility of a periodic charge.
Next think about making fully exempt gifts, such as, transfers to spouses or civil partners, the £3,000 annual gift, marriage gifts and small gifts. Although limited in value, these are outside of the estate immediately.
One of the most valuable exemptions is the gifting of surplus income. IHT is a tax on capital transfers, so transferring surplus income is not subject to IHT providing that the intention of the gifting is regular and that the donor retains sufficient income to maintain their standard of living.
Regular premiums payable under a whole of life policy written in trust may be covered by either the annual or the normal expenditure out of income exemption.
All these exemptions were discussed in an earlier article.
3. Chargeable Lifetime Transfers
Gifts to relevant property trusts should be made next. This will include discretionary trusts, accumulation and maintenance trusts, flexible trusts settled since March 2006 and so on.
4. Potentially Exempt Transfers
These are absolute gifts, for example made to individuals or to bare / absolute trusts.
Getting the order wrong could result in higher IHT bills on every tenth anniversary of a trust and when money is distributed to beneficiaries, but getting the order right could save the trustees time and money. For example, a gift of £325,000 to a discretionary trust (treated as a CLT), followed by the same amount to a bare trust (treated as a PET), could reduce the estate by £650,000 without any IHT consequences (subject to the seven year survival period). However, if a PET is made before a CLT, and subsequently fails, then it will reduce the nil rate band for the purposes of the periodic or exit charges.
As can be seen, careful consideration should be given to the order of gifting. Personal circumstances may dictate how and when gifts are made but gifting in the wrong order can result in an increased IHT bill.
This article, written by Kim Jarvis from Canada Life's Technical Services Team, first appeared on Professional Paraplanner's website.