The normal expenditure out of income exemption is one of the most effective, yet underused, inheritance tax exemptions. If the taxpayer makes payments (or intends to make payments) on a regular basis out of income, and those payments do not affect the taxpayer’s usual standard of living, those payments will be free of inheritance tax. It should be noted that withdrawals from investment bonds are not treated as income for these purposes, and this extends to payments made to the settlor from a loan trust or discounted gift trust.
There is no limit to the amount that can qualify for the exemption provided the taxpayer’s usual standard of living is not affected. However, in order to avoid HMRC challenging these payments after the donor’s death, it makes sense for the donor to keep a record of payments made. Recording such payments and income and expenditure on form IHT403 can ensure that all relevant information is collected and will also make the personal representatives’ job easier after the donor’s death.
The normal expenditure exemption is a perfect way for a taxpayer to cover premium payments made to a life policy in trust, to cover school fees payments for a child or grandchild or to meet other regular expenses of a donee. Where a taxpayer has a high level of surplus income and wants to reduce his or her taxable estate without physically placing the funds into the donee’s hands, the payments could be channeled into a discretionary trust for the general benefit of the selected beneficiary(ies).
As a trustee, the settlor could be given power to appoint benefits during his or her lifetime, and so control who benefits, by how much and when from the trust fund.
