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Inheritance tax - why giving away money can mean more for the beneficiaries

Newsletter issue - September 2021

In most cases, it doesn't make sense to simply give away money to save tax during a person's lifetime. For example, a higher rate taxpayer can claim tax relief to offset their income tax bill on qualifying donations made via the gift aid scheme. However, the cost of the donation will always exceed the relief, so it doesn't make sense to make additional donations purely from a tax perspective, though they can be useful for helping to avoid things like the high-income child benefit charge.

However, when it comes to the interaction with wills and charitable bequests, there can be circumstances where increasing the amount given away can actually mean there is more money left over for the beneficiaries.

Since 2012, a reduced rate of inheritance tax (IHT) of 36% applies where at least 10% of an estate is left to a qualifying charity. On the face of it this is simplistic, but as is often the case there are complications once the details are examined.

For one thing, it is not always necessary to bequeath 10% of everything owned. The estate is split into three components:

• Survivorship assets. Property owned jointly with others and which automatically passes to them upon death.
• Settled property. This refers to the part of the estate, if any, that is held in trust.
• Everything else. Charitable bequests are treated as coming from this first.

The 36% tax applies to any of these where 10% or more of it (after taking into account a proportion of the nil-rate band and other reliefs) is donated, i.e. so that the reduced rate may apply to some assets, but the full rate applies to others.

However, it is also possible to make an election to merge components and compare the charitable gifts to their aggregate value. If the gifts exceed 10% of the aggregated value, the reduced rate can apply to more than one component. Let's illustrate this with a straightforward case study.

Mark

Mark's estate is worth £1.2 million. This consists of family company shares worth £500,000, a joint share in the home worth £450,000 and chattels worth £250,000. Mark dies in 2021, leaving the company shares to his two children, £35,000 to a charity, and the remainder to his unmarried partner Karen.

There is no settled property, so we only need to look at the survivorship and general components.

Survivorship component

This consists of the interest in the property of £450,000, less the proportion of the nil rate band, i.e. £325,000 x (450,000/(450,000 + 250,000 - 35,000) = £219,925. So, the baseline the survivorship component is £230,075. Note that the residence NRB is not deducted.

General component

This consists of the family shares, less 100% BPR, i.e. £nil, as well as the chattels worth £250,000. The donation is treated as coming from this component for the purposes of calculating the baseline so the chargeable value is £215,000, less the remaining nil rate band of £105,075, i.e. £144,925.

The donation is therefore more than the 10% baseline for either component in isolation, for example the assets in the general component could be taxed at 36%, but the merging election wouldn't work here because the aggregated baseline is £375,000, so £35,000 is less than 10%.

However, the beneficiaries could make a deed of variation to increase the contributions. This could actually mean that they end up with more money.

Example

Charlie dies in 2021. There are no survivorship assets or settled property in the estate, which is worth a total of £1,325,000. Charlie left £80,000 to a cancer charity. The baseline here is £1,325,000 less the nil rate band, i.e. £1 million. As the donation is not at least 10% of this, the £920,000 net estate is charged at 40%, i.e. a bill of £368,000. The beneficiaries will receive £877,000. However, if the donation was increased to £100,000, the 10% test would be met. The IHT bill would be £324,000. The beneficiaries would receive £901,000, i.e. the additional £20,000 donation has actually saved them money due to the reduction in IHT of £44,000.

While it won't always pay to make additional donations, this should be kept in mind when drafting wills, or when looking at death estates where some charitable donations have already been made.