Charity legacies: the 10% conundrum

Since April 2012, estates which make a charitable legacy of at least 10% have benefited from a reduced rate of inheritance tax (IHT) at 36% rather than the standard 40%. This means that for every £100 of charitable legacy, the IHT on the estate is reduced by £76. Three years on, what have been the practical implications of this tax “concession”, and is it as attractive and effortless as it appears?

Previous Journal articles (April 2012, 28; October 2011, 24) have considered the mechanics for calculating whether or not the reduced IHT rate applies. By way of reminder, the deceased’s estate is divided into three components, namely the general component (property passing under the will), the settled property component (where the deceased had an interest in possession), and the survivorship component (property passing by way of survivorship destination).

The reduced IHT rate can apply to the IHT payable on any one or more of these components after calculating the net baseline amount of each component (the components can also be combined for this purpose). The “baseline” amount takes into account the total value of the property in that component, including any charitable gift, less any liabilities, available nil rate band, exemptions or other reliefs. The value of the charitable gift must be at least 10% of the baseline amount for that component to qualify for the reduced IHT rate.

Drafting possibilities

The legislation is complex. In an attempt to provide guidance and clarity, the Society of Trust and Estate Practitioners (STEP) produced a model charitable legacy clause in 2013 which could be included in a testator’s will in order to qualify for the reduced IHT rate as follows:

“1.1 I give to [charity/charities name] such a sum as shall be equal to 10% of the baseline amount in relation to the general component of my estate.

“1.2 In this clause ‘baseline amount’ and ‘general component’ have the meanings given to those in terms of Schedule 1A of the Inheritance Tax Act 1984.”

Where the testator intends the reduced IHT rate to apply across their entire estate, clause 1.1 can be amended to :

“1.1 I give to [ ] such a sum as shall be equal to 10% of the baseline amount in relation to the aggregate of the general [insert other component(s)/reservation of benefit property] of my estate.”

A well drafted will should also include the standard charity receipts clause and a clause allowing the executors to abate assets in favour of the charitable legacies to meet the 10% test in the event that there are insufficient assets within to pay all the intended legacies.

It is, however, impossible to predict precisely the value of a testator’s estate on death and therefore the amount which will constitute this 10% figure. If an estate has greatly appreciated in value by the date of death, using clause 1.1 could mean that a charitable gift is made on the testator’s death which far exceeds what they originally intended, when perhaps they would have preferred the surplus to pass elsewhere. Leaving a stated sum to charity in the will rather than a fixed percentage runs the risk of failing to meet the 10% test.

STEP provided further model clauses allowing the testator to fix a minimum and maximum charitable cap by amending clause 1.1 as follows:

“…Provided always that the legacy given by clause 1.1 shall: (a) not be less than £X; and (b) shall not exceed £Y even if the result is that the lower rate of tax shall not apply.”

Specifying a maximum value also runs the risk that the legacy may not meet the 10% test at the date of death, so the value of the estate would need to be regularly monitored. There is no clear answer to this. Ultimately the testator must decide when drafting their will whether their priority is to make charitable legacies, or to benefit from a reduced IHT rate. If the latter, the clause should be qualified through topping and tailing to achieve this desired result.

The known unknowns

Clients should be advised of the difficulties of calculating the value of the estate and the 10% charitable legacy for these purposes. For an individual with multiple investments, an unpredictable economy and fluctuating house and interest rates make it impossible to fix a precise value. In addition any lifetime gifting will affect the IHT threshold if made within seven years of death. The future nil rate band available at the time of death will also be unknown when the will is executed. Similarly, the availability of a transferable nil rate band (NRB) if a spouse predeceases will be unknown. Based on the current NRB of £325,000 per spouse, it could be that £650,000 of the estate is not liable to IHT on the second death. Given our aging population, there is also the likelihood of savings being depleted to fund nursing home costs later in life.

One alternative is to use a deed of variation to obtain the reduced IHT rate, if all the beneficiaries are agreeable. A deed of variation can be completed post-death to top up a charitable legacy to satisfy the 10% threshold. If, for example, the deceased had intended to give 4% of the net estate to charity, the gift could be increased to 10% under a deed of variation without affecting the share that the beneficiaries would each receive. To obtain the IHT relief the charity should countersign the deed of variation to show that they have been notified of the change. However, there is no duty on the executors to advise the beneficiaries of IHT planning, and the client will incur additional costs by putting a deed of variation in place. Should the onus be on the charitable sector to make the public more aware of the advantages in using a deed of variation? Deeds of variation are currently under Government scrutiny and may not survive following the general election.

An executor must actively claim the reduced IHT rate by completing an IHT430. It is therefore possible to opt out of claiming the reduced IHT rate, if the beneficiaries are agreeable, to make it easier to deal with the estate.

Finally, it is difficult to comment on the concerns raised within the charity sector when this tax concession was first introduced. One concern for charities was that donors may favour donating by charitable legacy rather than lifetime giving, since the reduced IHT rate provides a greater tax saving than a donation made under gift aid, where the donor obtains relief at their highest marginal rate of tax (i.e. 50% relief under gift aid compared to 76% under the reduced IHT rate). It has to be hoped that most donors choose to give for altruistic reasons rather than for tax reasons alone, so that lifetime giving should be unaffected.

Clients have shown considerable interest in this IHT concession. As we have seen, however, the complexities of valuing an estate and the 10% charitable legacy mean it is not always as straightforward a process as the client may envisage. The ongoing monitoring of the value of an estate, assessing the IHT liability at the reduced IHT rate or implementing a deed of variation will increase the costs to the client and the estate. The percentage of estates that will actually benefit is also questionable. There are many other ways to reduce IHT liability, including payments out of income and making use of the annual exemption, that clients should be aware of. That said, however, charitable legacies are vital to the charity sector and it is important that clients are informed of this IHT concession where relevant.

When cash just isn't good enough

“Charities and not-for-profit organisations familiar with holding large cash reserves will have to rethink their strategies or risk eroding assets through inaction.” See the article on Journal online: bit.ly/1KiX9ri