Give more to charity so HMRC takes less from an estate

After the government reduced the rate of inheritance tax (IHT) from 40 per cent to 36 per cent, when at least 10 per cent of a deceased's net estate was left to a good cause, it was hoped that charities would benefit from further millions each year. But so far the impact has been much less than anticipated and many testators and their families are missing out on an effective tax mitigation and philanthropic opportunity.

The 36 per cent IHT rate applies when 10 per cent of the "baseline amount" is donated to charity. Effectively, this is the net value of the estate, less any available nil rate band(s) and any other exemptions and relief on death (other than charity relief). Accordingly, if P dies and his net estate is worth £1m, his wife pre-deceased him and her full nil rate band is transferable, P's baseline amount is £350,000 (£1m less £325,000 doubled). P should leave £35,000 or more to charity for the estate to benefit from the reduced IHT rate.

Calculating the net value

An example demonstrates how this benefits not only the charity but also the beneficiaries. In fact, only HMRC may lose out.

Alice, a spinster, died leaving £575,000. Under her will, she gives £20,000 to Oxfam and the rest to her nephew, John. Oxfam receives £20,000, HMRC collects £92,000 and John inherits £463,000. If Alice increased her charitable giving to £25,000, it would be divided as follows: £25,000 for charity, £81,000 for HMRC and £469,000 for John, which is £5,000 more for charity and an extra £6,000 for John.

When considering the reduced rate, the deceased's taxable estate is divided into three components:

• the survivorship component - assets the deceased owned as a beneficial joint tenant, passing by survivorship on death;
  

• the settled property component - trust assets in which the deceased had an interest in possession; and
  

• the general component - remaining assets within the deceased's estate for IHT purposes - essentially the free estate.
  

The 10 per cent test is applied to each component with the available nil rate band apportioned between the components. An election can be made to merge the components so that they are treated as one single component. This is useful when the donated amount to charity from a particular component exceeds 10 per cent of the baseline amount and the 10 per cent test is met by the combined component.

Fear of the unknown

Many testators will be put off by not knowing what 10 per cent of their estate will be on death. STEP's draft will clause has a useful formula, which essentially sets out how the 10 per cent should be calculated. However, uncertainty remains as to how much will be left to charity, and testators could cap the legacy in the will- but risk losing the benefit of the reduced rate - or set a minimum amount.

A better alternative would be for a testator to establish a discretionary trust, including charities as potential beneficiaries. A letter of wishes would ask the trustees to appoint an amount to charity to meet the 10 per cent test within two years of death, with any requirements for minimum amounts, etc.

Beneficiaries can decide to complete a deed of variation to use the lower IHT rate, when they will have certainty as to the estate value and the potential IHT saving. When a probate matter lands on the desk, and the deceased clearly showed charitable intention, it is always worth doing the calculations to see if charities and beneficiaries can benefit from the reduced rate. Where a testator provides a charity gift of over 4 per cent, and less than 10 per cent, of the baseline amount, the net estate is increased so it is clearly worthwhile.