Tax Corner: Orderly gifting?
QUESTION: I am considering making a substantial gift to my children and also setting up a discretionary trust for their future benefit. Are there any tax matters that I should be wary of?
ANSWER: In the UK, it is possible to gift unlimited amounts of money without incurring an immediate charge to inheritance tax (IHT). Such gifts are called potentially exempt transfers or “PETs”.
If, however, the transferor dies within seven years of making the gift, the gifts are included within their estate for the purposes of computing the estate inheritance tax liability. Such gifts are referred to as “failed PETs”.
This contrasts sharply with the treatment of a lifetime gift into a discretionary trust. Such a transfer is immediately chargeable to inheritance tax at a lifetime rate of 20 per cent. However, if the value of the transfer into the trust is less than the inheritance tax nil rate band (£325,000), then the transfer into the trust is not subject to the immediate 20 per cent charge. Should the transferor survive for seven years he/she regains their lifetime IHT exemption of £325,000.
A complication can arise however where PETs are made and then subsequently a discretionary trust is set up and transfers are made into it. If the person dies within seven years of the PETs, the failed PETs become chargeable to inheritance tax and affect the order in which the nil rate band of £325,000 is used. What this means is that the £325,000 is now applied against the earlier failed PETs instead of the transfer into the discretionary trust.
The result of this is that the beneficiary of the now failed PET may have a tax liability to pay if the PET exceeded the nil rate band of £325,000 and by that stage (up to seven years after receiving the gift), the cash may now be spent. Taper relief can reduce any IHT charge where the transferor has died between three and seven years from the making of the gift.
Furthermore, because the PET was made before the discretionary trust settlement, periodic and exit charges for the trust could be impacted. A discretionary trust is assessed to inheritance tax every ten years or whenever capital is transferred out of the trust (an exit charge). The trust has its own nil rate band for calculating these periodic and exit charges, but in this scenario the nil rate band is reduced by any chargeable transfers, including failed PET’s, in the seven years before the trust was created.
The order of gifting therefore is very important if you are planning to make a series of gifts, whether they be outright gifts or gifts into a discretionary trust as the order they are made in can affect subsequent trust charges. The recommended order of gifting is to make the chargeable lifetime transfer into the discretionary trust first and then make the potentially exempt transfers.
Finally, if you are considering making lifetime gifts in excess of the £325,000 inheritance tax nil rate band, you should limit the transfer into the discretionary trust to no more than £325,000 and apply the balance of the amount of gifting towards PETs as this will avoid a lifetime IHT charge.
Paddy Harty (email@example.com) is a senior tax director at PKF-FPM (www.pkffpm. com). The advice in this column is specific to the facts surrounding the question posed. Neither the Irish News nor contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.