Many factors can drive a client's wish to give away assets.
It is the job of the professional adviser, whether from a legal, tax or financial planning perspective, to understand the client’s objectives before determining how best to achieve them.
Is it to save tax and maximise wealth within the family unit? Is it to help the next generation with the costs of education or buying a house? Does the donor want to test the financial responsibility of the recipient before making more significant gifts, either later in life or on death?
Here we'll discuss these issues and the related aspects to consider for clients gifting wealth. We'll concentrate on the scenario of parents gifting to children, but most of the points apply to other relationships as well.
Capacity to gift
If the client’s mental capacity to make a gift is in doubt, the professional adviser must exercise caution. The level of capacity depends on the circumstances. A gift of a trivial amount for example requires a lower degree of understanding than a gift of the client’s principal asset.
An attorney under an enduring power of attorney (EPA) or lasting power of attorney (LPA) has extremely restricted statutory powers to make gifts on behalf of an incapacitated client, even if there's a history of gifting surplus income or using the annual exemption.
Interestingly, a deputy appointed by the Court of Protection for a client without capacity and without a valid EPA or LPA does not even have these restricted gifting powers.
For attorneys wanting to gift outside their statutory powers and for deputies wanting to make any sort of gift, an application to the Court of Protection is needed. This should evidence how the gift is in the client’s best interests.
Financial planners have a key role in supporting these applications, with cashflow modelling showing the impact of the gift on future financial security.
Is the gift affordable?
While lawyers and accountants can advise on the legal and tax implications of a gift, they cannot usually say how much should be given. As a result, they will look to you as the financial planner for help.
Advice on the immediate and longer term affordability of gifts will also cover alternatives to gifting such as discounted gift trusts, business property relief investments, making loans to the next generation or co-purchasing assets with them. It all comes back to knowing the client’s objectives, whether tax-focused or not, and finding the best solution to meet them.
Transferring control and ownership
Another risk area is the client who can’t quite let go of the asset to be gifted.
On the one hand, there’s the parent who can’t let go financially and needs the income or capital back at a later stage. Gifting in this way risks triggering the inheritance tax (IHT) reservation of benefit rules or the pre-owned assets income tax charge. This comes back to the question of affordability.
On the other hand, there is the parent who can afford the gift but wants to influence what the child does with it. It may be that a cash gift is made on the understanding that it's used to buy a property, or a gift of an heirloom for it to remain in the family for future generations.
The parent wanting this kind of continuing control has a choice.
They can gift to the child outright (or to a bare trust for them), and simply hope that their parental guidance is enough.
Alternatively, they can gift to a more structured trust which passes the ownership and control to trustees. If they go with this option, they have to accept the tax and administrative burdens of the trust and the £325,000 gifting limit in order to avoid an immediate IHT charge.
Protecting the asset from third party claims
While parents may trust their child, events out of the child’s control can lose wealth when it comes to settling claims against them by third parties.
A parent gifting outright to their child must appreciate that the asset is then liable to settle financial claims against the child. The asset will pass through the child’s own will to their chosen beneficiaries on death, and will also be treated as a matrimonial asset in the event of divorce.
Although gifting to a trust rather than the child is an option, it doesn't guarantee long-term wealth protection.
For gifts that have already been received or are anticipated in the future, there is the option of either a pre-nuptial or post-nuptial agreement. That way, couples can agree how any gifts are treated in the event of marital breakdown.
For some clients, treating their children equally is not important, as it may be the one with the greater financial need will be favoured. Others want to treat everyone equally, and be seen to do so.
The key is to establish what's important to the client and make sure it can be achieved.
This may be ensuring that all lifetime gifts are made equally or, if not, including a ‘hotchpot clause’ in the will. This acts to equalise gifts when distributing the estate on death, but the professional adviser will need to check that there will in fact be enough in the estate to equalise after expenses and tax have been paid.
Tax traps and missed opportunities
Often the gift is driven by a wish to reduce the estate subject to IHT on death, but advisers mustn’t lose sight of other tax implications as well. These include:
- Capital gains tax (CGT) on gifts, the availability of hold-over relief for gifts of business assets and gifts to most types of lifetime trust, and the restrictions where the beneficiaries are minor children or are (or become) non-resident.
- IHT reservation of benefit rules and the pre-owned assets tax charge.
- IHT taper relief. This is a reduction in the tax and not in the value of the gift itself, meaning it has no application for failed gifts within the nil-rate band.
- Maintaining records of lifetime gifts and, in particular, of those from surplus income to help personal representatives support their post death claim for IHT exemptions.
- Capturing the residence nil-rate band (now at £300,000 for a couple) by reducing the estate to below the £2m threshold. It's also worth reviewing the will to make sure the right people are benefitting from the residence or its proceeds in the right way.
- Avoiding the parental settlement rules. These cause a parent to be taxed on the income paid to their minor child where the parent has created the trust for them (including a bare trust).
- The tax impact on the person receiving the gift in terms of their future liabilities to income tax, IHT (including their liability to pay IHT on the gift if it becomes chargeable), CGT and stamp duty land tax. This may well prompt discussions about life cover and 'generation skipping' to take advantage of lower tax rates.
Overall, helping clients and their families with the opportunities of gifting wealth and navigating the numerous traps needs legal, tax and financial advisers working together to give rounded and tailored advice.
As mentioned at the start, all of this requires a solid understanding of the client, their circumstances and their objectives.