How to take advantage of the 'normal expenditure' exemption and avoid Inheritance tax

An inheritance tax exemption that is often overlooked is the exemption for 'normal expenditure out of income'. Where this applies it can lead to amounts paid to family/relative/a trust to be excluded from a deceased's estate when calculating any inheritance tax charge. In order for payments under the normal expenditure out of income exemption to be exempt, the following conditions must be satisfied: - the transfer must be made as part of the normal expenditure of the transferor - it must be made out of his income - after allowing for all transfers forming part of his normal expendiure, the transferor was left with sufficient income to maintaion his usual standard of living. All three conditions must be satisfied and the onus is on the tax payer to show that they are all satisfied. HMRC accept that it could be that only part of a transfer actually meets the conditions and you'd therefore have a situation where part of a gift was excluded from the estate and the remainder was included. 'Normal expenditure' means that based on the particular transferor, the payment was typical for them. Ideally a regular pattern of payments should be made, or an agreed percentage (eg 10%) of net income would need to be shown to be paid to the recipients. One way that expenditure could be classed as 'normal' would be for an individual to have assumed a commitment or adopted a firm resolution regarding his future expenditure and thereafter complied with it. There would therefore need to be evidence supporting the regular payments. This could be a simple family agreement indicating payments to be made by (for example) a father to his children. A common example is where a specific payment is to be made monthly or annually . This could be (for example) payments of £2,808 per tax year into a stakeholder pension for the benefit of a child. If a regular cash transfer is to be made to a child, a good option would be to consider making any payments under a deed of covenant. This would be likely to satisfy HMRC that a pattern of expenditure will be in place. In essence the final condition above relates to whether the deceased would have sufficient income to live on after making the transfers in question. His usual standard of living is taken to generally be the standard prevailing at the time of the transfer. HMRC could therefore look to see details of the net income of the deceased and compare this with the usual costs of living they incur. Frequently Asked Questions on this exemption Here's some of the top FAQ's that people have when considering this exemption. When considering regular payments from income, do you take gross or net income? Net income Do I need to survive for a certain number of years for the payments to be exempt? No, unlike potentially exempt transfers there is no survivorship requirement and you would avoid Inheritance tax on the payments made irrespective of the survivorship period Does there have to be a worthy purpose for the regular payments or can they be for anything to anybody? No for this exemption there is no specific requirement as to the purpose of the payment Must any beneficiaries be of a minimum age to receive payments? No Are there any problems with beneficiaries that are non UK resident? No. Can the money be saved by the younger beneficiaries for future education costs? Yes Could I pay for my care home out of capital and give all of my income away to avoid Inheritance tax under this exemption? No you could not. Ine of the requirements is that you must have sufficient income remaining after any gifts such that tou can maintain your standard of living. Payment of carehome fees out of capital would prevent the exemption applying. Is it better to give away excess income and be taxed on the full estate at death, or give large sums of money now to children as potentialy exempt transfers ('PETs')? This is the $64,000 question and would probably depend crucially on the size of the estate in question. If the estate was large it may well be worthwhile considering a transfer of a proportion of any capital to reduce the estate to the value of the nil rate band. This would be a PET, and provided the person making the gift survived for at least 3 years, a form of taper relief would apply to potentially reduce the amount of IHT charged. If he survived for a period of seven years after the date of the gift , the value of the gift would be excluded from his estate for IHT purposes. These PET's could also be combined with regular payments out of income, to further reduce the size of any estate although these would presumably be reduced as the available income would also be reduced.