Could your loved ones be at risk of a surprise Inheritance Tax bill?

Anyone making large gifts to loved ones during their lifetime is being warned it could see their family or friends stung with a surprise tax bill after they’ve died. 

A recent freedom of information request to HMRC, from wealth planning firm Evelyn Partners, has revealed that the number of estates that paid Inheritance Tax (IHT) on gifts made in the last seven years of someone’s life has doubled. 

Rising from 590 in 2011/12 to 1,300 in 2020/21 (the latest figures available), the amount of IHT paid on gifts has jumped too: from £101m to £256m over the same period. 

The report suggests people were paying, on average, £196,923 by 2021 for lifetime gifts - so if a donor is unaware of the rules on gifting money, the recipient could be in for an expensive tax bill. 

“Those who receive generous gifts from older relatives need to be aware that they could be liable for a big tax charge if that relative dies within seven years of making the gift,” says Ian Dyall, Head of Estate Planning at Evelyn Partners. 

“These figures show that a growing number of recipients will have had a potentially unexpected IHT bill to pay when the donor dies, on a gift that they could have received several years ago.” 

Shaun Robson, Partner and Head of Wealth Planning at Killik & Co, agrees, highlighting financial pressures on families leading to some individuals being particularly generous. 

“We have seen an increase in interest from clients wanting to make significant gifts, especially to help with school fees, being driven by both grandparents and the parents of those kids in school,” he says. 

Sean McCann, Technical Advice Manager at NFU Mutual, adds the reason for more gifts being given is due to the frozen thresholds for when IHT is triggered: “Because of the rise in the value of property and investments in recent years, many more people are finding themselves caught in the [IHT] net.  

“To try and reduce any potential IHT bill for their families, a growing number of people make gifts during their lifetime.” 

When can lifetime gifts be taxed? 

Giving money while they’re still alive can be a helpful way for some wealthy individuals to reduce the IHT that will need to be paid on their estate and pass money on to younger generations – sometimes called a ‘lifetime gift’.  

The idea is that beneficiaries get the full value of the gift while benefactors get to enjoy seeing the difference their wealth can make to loved ones while they’re still alive. 

To work out whether anyone in your family could be faced with a retrospective bill, it’s important to understand the tax rules on lifetime gifts and why it’s not a foolproof way of mitigating IHT. 

When you give away money during your lifetime it won’t automatically leave your estate for IHT purposes. Instead, it’ll be regarded by HMRC as a ‘potentially exempt transfer’ or PET. 

(This is unless it falls within one the designated IHT gifting allowances, such as the annual gift exemption that currently allows you to give away £3,000 per year to anyone, and won't count towards the value of an estate). 

In some cases, if a donor dies before seven years have passed after giving away substantial sums, the recipients could be faced with a tax charge. 

Dyall explains: “During the administration of the estate, the executors need to list all the gifts made within the last seven years - and any gifts made within seven years of the earliest of those gifts - so HMRC will be aware of all the people potentially liable to IHT on the death of the donor.” 

He continues: “If at the time the gift was made, the gift (plus any other gifts within the last seven years) exceeds the nil-rate band then the recipient will have a liability on the excess if the donor dies within seven years.   

“If the total of the gifts is within the nil-rate band, then there will be no liability for the recipient, but instead the nil-rate band available to the executors on death will be reduced leading to more tax on the estate.” 

The tax that could be charged on a PET will be based on the length of time you lived after making the gift, with something called taper relief gradually reducing the rate of IHT from 40% to 0% over time. This is why you’ll often hear it referred to as ‘the seven-year rule’.

Dyall says another issue that many people are unaware of is that gifts use up the nil-rate band in chronological order.   

“If child A receives £300,000 from the donor today and child B receives £300,000 from the same donor tomorrow (assuming no other gifts) then child A’s gift is covered by the nil-rate band so they will never have a liability. 

“However, child B only has the remaining £25,000 of the nil-rate band to offset against their gift, so if the settlor dies within seven years, they may have a liability on the remaining £275,000.” 

This can cause significant disagreements if beneficiaries are unaware of this prior to receiving a gift, so it’s worth communicating the plans to them, ensuring everyone understands and decisions can be made if needed. 

Can you beat the charge on gifts? 

For anyone that has made – or received – a large lifetime gift, the prospect of a tax charge will invariably be a worry. It will also be a concern for those that are still exploring ways to help younger members of their families and cut their IHT bill. 

Whether you’re a benefactor or a beneficiary, it’s a good idea to seek professional advice. That should help you work out where you stand and give you an overview of your options. 

Dyall says: “A big lesson for those planning the transfer of their assets to the next generation is that it can be quite tricky to make lifetime gifts that are 100% safe from IHT.  

“Anyone receiving a big gift from an elderly relative might want to assess the tax situation before they either spend it all or plough it into something illiquid like a property.” 

For those that want to give money away without worrying whether they’ll live the seven years required for the gift to become tax free, Dyall says it’s also worth exploring alternative options.   

“It is easy to exceed the annual gifting allowances - unwittingly or otherwise - as these exemptions have been frozen at their current levels since 1981 and would be far more generous had they risen with inflation.  

“One of the few ways around these relatively meagre allowances - without the gifts counting as PETs - is to make regular gifts out of surplus income.” 

So long as your executor – who will be responsible for paying any IHT due on your estate – can prove that your gifts were regular, paid out of income (rather than capital, such as savings) and didn't have an impact on your standard of living, they’ll come out of your estate immediately and no IHT will be payable on them.  

If you start early enough, this can be a helpful way for wealthy people to get large sums out of their estate. However, it does mean you need to keep scrupulous records of your gifts, your income and your expenditure, to ensure you meet HMRC’s criteria. 

Alternatively, anyone worried about not living seven years could consider taking steps to cover a potential IHT charge.  

Dyall adds: “If you are looking at how any liability may be covered, it is possible to take out a term life assurance policy for seven years, written in trust, so that the money is available, prior to probate, to pay the IHT on any gifts that fail to reach the seven-year point.   

“Alternatively, they could put an investment in a trust, so that money is available prior to probate to pay the liability.” 

However, the use of trusts can be complex and there may be potential tax charges and costs for setting them up, so getting professional help to create them is crucial. 

If someone is considering a life insurance policy, it’s also important they think about its ongoing cost to ensure they can continue to pay it for the entire period. 

Key takeaways: 

• Many lifetime gifts will only be free of IHT if the donor lives for seven years after making it. 
• If somebody gives away more than the value of the nil-rate band during their lifetime and dies within seven years, the beneficiaries of those gifts may face a tax charge. 
• Regular gifts from surplus income are IHT-free immediately – but donors need to be able to demonstrate that they could afford to make those gifts from income and without impacting their standard of living. 
• If you’re planning to give away large sums of money before you die, it’s important to get professional advice.