Inheritance tax planning – what are exempt normal gifts out of income?

For many landowners and farming families, most of their wealth is tied up in land and property rather than readily available cash. While reliefs such as Agricultural Property Relief (APR) and Business Property Relief (BPR) remain important, recent restriction of those reliefs has increased the focus on lifetime planning. 

One effective strategy now more regularly discussed is the inheritance tax (IHT) exemption for normal expenditure out of income. This allows certain gifts to be immediately exempt – i.e. without the usual seven year waiting period.

Gifts can be exempt from IHT if all three of the following conditions are met:

1. The gift forms part of the donor’s normal expenditure. 

2. The gift is made from donor’s income. 

3. After making the gift, the donor is left with sufficient income to maintain their usual standard of living

HMRC guidance makes clear that it means normal for the individual, not for the average person. The focus is on whether the gifts form a pattern. 

This pattern can be shown in one of two ways: 

• A series of regular payments over time, for example, annual or monthly gifts, or
• Evidence that there was a clear commitment to make such gifts on an ongoing basis, even if the gift history is short. 

Whilst it is preferable to have a history of say three to four years to establish a pattern of giving, the courts have confirmed that even a single gift can qualify if it can be shown and is documented to be the first in an intended pattern.

Income for these purposes is not limited to taxable income and does not follow income tax definitions. It may include:

• Drawings of profits from a farming partnership
• Rental income
• Dividend income
• Pension income 

ISA income and other non taxable income 

Helpfully for farmers with fluctuating profits, HMRC apply a “taking one year with another” approach, allowing income to be averaged over time. However, accumulated income can become capital if left unspent for too long, so regular planning and clear evidence are essential.

The donor must retain enough income after making the gifts to maintain their normal standard of living. If gifts force the donor to use capital to fund everyday living costs, the exemption will fail. Therefore, careful record keeping is required of annual living costs.

Common examples include helping fund children’s housing costs, grandchildren’s school fees, or regular support for younger generations involved in the farming business.

Given the proposed changes to bring pension funds into the scope of IHT from April 2027, many are considering withdrawing their pensions, either taking their 25% tax free lump sum or paying income tax, with a view to gifting the net of tax income onto the next generation to reduce the IHT on death. However, HMRC may yet have counter arguments to this type of planning. 

Income for the purposes of the exemption is not necessarily the same as taxed income. While regular pension withdrawals may qualify, a large lump sum withdrawal taken to reduce the IHT pot, may be deemed capital and not surplus income.

The exemption is usually claimed on death, so contemporaneous records are vital. HMRC will expect to see clear evidence that the conditions were met. Therefore, best practice would be to keep:

Annual income and living expenditure schedules 

Evidence of the source of gifted funds 

A clear written statement of intent to make regular gifts

Consistent patterns of gifting over time 

Without adequate records, HMRC may deny the exemption, even if the gifts themselves looked reasonable. As the exemption must be claimed it is recommended that each year page 8 of Schedule IHT403 or a similar spreadsheet is completed and retained with your will.