How can a charitable gift reduce the inheritance tax due on my estate?

Many people decide to include a charitable gift in their Will in the knowledge that charities depend heavily on such giving.

All gifts made to charity – whether during your lifetime or in your Will – are exempt from inheritance tax (Section 23 Inheritance Tax Act 1984). The size of the gift makes no difference and some wealthy people do choose to make substantial gifts to charity during their lifetime which (unlike lifetime gifts to friends and family) do not impact their inheritance tax position.

Others decide to leave a gift in their Will – for example, a straight gift (“I give £1,000 to St John’s Ambulance”) or a gift of their residue. They might, for example, give their children the income from their assets for life with the remainder to charity. Careful consideration should be given as to whether this income is substantial enough to be of value, particularly where the beneficiary is maintained by the Testator financially.

Note that if a Deceased person did not leave a gift to charity but the beneficiaries of the Deceased person’s estate wish to alter this position, they can do so within 2 years of the death using a Deed of Variation. This is treated as being ‘read back’ into the Will (in other words, as if the replacement words in the Deed were actually written by the Testator).

Where the Deceased died on or after 6th April 2012, a reduction from 40% (the standard inheritance tax rate) to 36% is available where the Deceased leaves enough of their estate to charity (Section 207 and Schedule 33 of the Finance Act 2012 which inserts a new Schedule 1A into the Inheritance Tax Act 1984).

Of course, gifts to charity are exempt from inheritance tax so if the Deceased left their entire estate to charity, there would be no inheritance tax to pay. However, the new provisions offer an incentive to those who might leave a slightly smaller but nonetheless generous gift. They mean that sometimes gifting a little higher can mean the other beneficiaries receive more.

Generally speaking the reduced rate of inheritance tax will be available where 10% of the net estate (known as ‘the baseline amount’) is left the charity. If the Deceased’s estate did not contain any property passing by survivorship or any trust property that he is deemed to own then it is very easy to calculate the baseline amount – it is simply the value of the estate, less the funeral expenses and debts, taking into account any
exemptions and reliefs and the nil rate band (inheritance tax allowance).

So, for a simple example:

James dies leaving assets worth £1,000,000 in his sole name.

His debts and funeral expenses total £10,000.

He leaves £60,000 to Oxfam and the rest to his son George.

He does not make any chargeable transfers in the seven years prior to his death.

Assume the RNRB does not apply. The ‘baseline amount’ is:

£900,000 estate
£10,000 funeral expenses and debts
£325,000 available nil rate band
Baseline amount = £565,000

Because the gift of £60,000 is at least 10% of the net estate (the baseline amount), the 36% inheritance tax rate applies.

To calculate the tax payable:

Estate £900,000
Debts and funeral expenses £10,000
LESS exemptions (charity) £60,000
Chargeable estate £830,000
First £325,000 @ 0% (nil rate band – i.e. inheritance tax allowance)
£505,000 @ 36%
Total tax £181,800
Amount to charity £60,000
Amount to son George £648,200

If the gift left to charity did not amount to 10% of the net estate – for example, if it was just £40,000 – the inheritance tax due would have been  £525,000 x 40% = £210,000 and George would have received just £640,000. So if you are making a gift to charity in your Will that is around the 10% mark, it makes sense to ensure the amount is always above 10% – otherwise the remaining beneficiaries may lose out.

When drafting your Will it won’t be possible to state an exact amount if you want to be certain that the 10% requirement is met, so instead it is more sensible to use a formula. If a relative has died and just missed the 10% mark, remember that it’s possible to make a post-death Deed of Variation which ‘writes back’ the terms of the deed into the Will. This could leave both the Deceased’s chosen charity and their other beneficiaries better off.

Calculating the baseline amount is more difficult if the estate includes:

(a) property that passes by survivorship – for example, if a house was owned as ‘joint tenants’, the house automatically passes to the survivor on the first death; and/or

(b) property that is held within a trust where the Deceased was deemed, for inheritance tax purposes to own the capital. This is the case where the Deceased had a life interest – so for example, if Julie is given the right to live in ‘Greenacre’ for life with the remainder to her sister, on her death the value of Greenacre will be  notionally included in the total value of her estate when calculating inheritance tax – even though she never actually owned it; and/or

(c) property that has been gifted where a reservation of benefit has been retained. For example, if you give your house to your children but continue to live in it, this will be treated as forming part of your estate for inheritance tax purposes, even though you do not actually own it.

(d) ‘general property’ that does not fall into the above categories.

Where the estate includes any of the above, the components are looked at separately. If at least 10% of the component is left to charity, the 36% reduced rate is available  for the rest of the component.

As an example, Clare has a life interest in her father’s house which is worth £600,000. 60% of the house will go to the charity Marie Curie when she dies, and 40% will go to her children. This falls into category (b) above. More than 10% of the baseline value of this category will go to charity, so the 36% reduced rate is available in respect of the 40% passing to Clare’s children (there is, of course, no tax payable on the 60% that goes to the charity).

To add a further layer of complication, where an estate is made up of more than one component, the nil rate band (inheritance tax allowance) has to be apportioned between the different components. It is possible to elect to merge the components and treat all the merged property as one for the purpose of the 10% net value test. This would likely be useful where a large proportion of one component was left to charity – if significant enough, it may attract the reduced rate on the whole of the merged value.

To gift on death or during one’s lifetime?

A number of schemes exist which make lifetime giving tax effective. These include:

Charitable gift relief – ss 431 and 434 Income Tax Act 2007

Payroll giving – Section 713 Income Tax (Earnings and Pensions) Act 2003

Gift aid – ss 414–416 Income Tax Act 2007

These are especially attractive to higher rate tax payers.

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