What is a gift inter vivos policy and when should it be used?

In the financial world a gift inter vivos policy relates to an insurance policy used to cover the inheritance tax liability that can arise when an individual makes a gift to another person whilst they are alive and, absent of any other exemption, potentially liable to inheritance tax for the next 7 years.

Everyone has a personal inheritance tax allowance, known as the nil rate band. This is the amount of their estate that is completely exempt from any liability to inheritance tax and is currently £325,000 although some people will have a higher allowance depending on their circumstances.

Assets an individual passes on above the nil rate band are currently taxed at the inheritance tax rate of 40%. Fortunately, in addition to the nil rate band there are special rules relating to these lifetime gifts which help to limit, or reduce, the liability.

Gifts made to anyone from an individual’s estate are exempt from inheritance tax provided they survive for a period of 7 years after the date the gift is made. These lifetime gifts are known as potentially exempt transfers (also known as PETs) and are not restricted in value.

Should an individual die within this 7-year period there is still a potential liability to inheritance tax, which in certain instances reduces over the period. This reduction in liability is commonly known as taper relief. An individual has a full 40% liability if they die shortly after they make the gift but gifts made 3 to 7 years before death are taxed on a sliding scale.

The most common way of protecting the beneficiaries of these gifts from the potential tax liability is to set up life assurance policies to cover the reducing liability. These are known as ‘gift inter vivos’ policies. These policies have a fixed 7-year term, with cover reducing in steps to match the reduced liability as taper relief takes effect. Although the cover reduces, the premium typically stays fixed for the whole 7 years.

However, before setting up a gift inter vivos policy it’s essential to establish whether taper relief will apply. Lifetime gifts are allocated against the individual’s nil rate band when they make them. This means the initial impact of any gift, or subsequent gifts, is to effectively reduce their nil rate band for the 7-year period, thereby increasing the liability on the residual estate during this time. Taper relief is also applied to the rate of tax not the value of the gift. So, if a gift falls within the nil rate band the rate of tax is zero and therefore taper relief has no effect.

Example

Let's assume an individual decides to make a gift with a value of £450,000. They have made no other lifetime gifts during the last 7 years and have used the annual exemption for gifts of £3,000. As the value of this gift exceeds their nil rate band by £125,000, taper relief will only apply to the rate of tax payable on this amount, not the full gift. A gift inter vivos policy for the taxation liability on this amount is therefore a suitable solution. So, in this instance a policy starting with £50,000 of cover which then reduces by £10,000 each year after year 3 would be recommended.

But there is something else to consider that people overlook.

In addition to setting up the gift inter vivos policy you should consider what liability remains on the rest of the individual’s estate. As the nil rate band has been used up, the beneficiaries of the rest of the estate have an increased liability until the gift falls outside of the estate and the full nil rate band is available again in 7 years. Unless the rest of their estate would be exempt from inheritance tax, for example because it’s all being left to a spouse or civil partner, they should consider covering this liability by means of a level term assurance, as taper relief does not apply to this sum. The cover needed is £130,000 equivalent to the 40% tax liability on the nil rate band. The policy term for this also needs to be set at 7 years.

Similarly, consideration should be given to the liability that remains where gifts are made that are below the nil rate band. For example, an individual has decided to make a gift with a value of £250,000 and as before, they have made no other lifetime gifts during the last seven years. As the value of this gift does not exceed their nil rate band, taper relief will not apply. In this case a gift inter vivos policy is not a suitable solution. Instead, they should again consider covering the increased liability upon their residual estate with a 7-year level term assurance for the sum of £100,000, this being equivalent to the 40% tax liability on the part of the nil rate band that’s been used.

What happens if you have cumulative gifts that combined are over the nil rate band?

Let's assume an individual makes a gift of £240,000 5½ years ago, and they have now decided to make a further gift with a value of £240,000. They now have £480,000 in total gifts, and are £155,000 over the nil rate band. So, you might think a gift inter vivos for £62,000 would work.

Unfortunately, this is a common mistake that people make.

In 1½ years the first gift will have been made 7 years ago, so drops out of the inheritance tax calculation. The remaining gift of £240,000 will then be less than the nil rate band, and therefore taper relief would never be able to apply to the later gift. A gift inter vivos policy for the taxation liability on this amount is therefore not a suitable solution. In this instance a level term assurance for £96,000, with a 7-year term, would be appropriate, this being equivalent to the 40% tax liability.

The story would be different though if instead of being a potentially exempt transfer, the first gift had been to a discretionary trust and therefore a chargeable lifetime transfer. In those circumstances, although there would be no further tax to pay on the first gift, it would still be considered in calculating the tax payable on the second gift. This is because to decide whether there is any tax to pay on the second gift you also need to look at whether there were any earlier chargeable transfers within the 7 years before the gift took place. In this case the earlier chargeable lifetime transfer plus the value of the second gift is more than the nil rate band and therefore the excess is chargeable if they die within 7 years of making the second gift. Taper relief would also be available and so a gift inter vivos policy would be appropriate.

So, we’ve discussed gift inter vivos policies and when they should and should not be used, but are there any other options?

Apart from the limited times that a gift inter vivos policy will meet the need, there is another problem with them, which is simply that there aren't many companies offering them. This means that they are sometimes not as cost effective as they could be. But there is an alternative, which is not quite as simple, but well worth consideration.

Multi-cover plan

Instead of the gift inter vivos policy, somebody could consider building a multi-cover plan, made up of a group of 5 level term assurance covers. These 5 covers run alongside each other with terms of 3, 4, 5, 6, & 7 years respectively. Each cover should be set at one fifth of the liability. For example, if you have gifts exceeding the nil rate band by £250,000, and therefore a 40% inheritance tax liability of £100,000, setting each of the five covers at £20,000.

This will provide full cover of £100,000 (5 x £20,000) from day one and for the first three years, at which point the first policy will cease. Thereafter, the total cover provided will decrease by £20,000 each year as the next policy in the multi-plan reaches its full term. After the end of year 3, you have 4 covers left, giving £80,000 cover. At the end of year 4 there are 3 policies left giving £60,000, and so on.

This reducing cover will match the reducing inheritance tax liability, in the same way as the gift inter vivos policy does. But there is an added benefit in that the premiums the individual pays will also reduce each year after year 3, as each of the individual covers cease. This can significantly reduce the overall cost. If they also need to cover the liability on the residual estate, they can add another level cover for that amount or combine it with the 7-year term cover.  Or if circumstances are even more complicated, and gifts have been made in different years, the cover can be tailored to meet the liability as older gifts drop out of the calculation.  The possibilities are almost endless meaning this is a much more flexible and cost-effective solution than traditional gift inter vivos policies.

Writing the plan in trust

It's strongly recommended that whichever policy option is selected it should be placed into trust.  This will ensure that the benefits from a claim on the policy are not added into the individual’s estate, which would increase the liability, somewhat defeating the purpose. It also means the policy does not get caught up in probate so can be paid to the beneficiaries quickly to pay the liability as soon as possible.

The trust can normally be set up using the life assurance providers own forms, at no added charge. The gift inter vivos policy should be for the benefit of the recipient of the gift as they are the person liable for paying the tax.  If the liability on the residual estate is being covered, this policy should be for the beneficiaries of the residuary estate to ensure the funds are available for the liability on the estate to be paid.

In summary, working out the liability on lifetime gifts can be a headache and there are many traps for the unwary, but doing it properly and making sure they are covered can really make a difference to your client.