Is it possible to reduce inheritance tax liability through charitable gifting in Wills?

Last year more than £3 billion was left to charitable causes through Wills alone. Care needs to be taken to ensure that the clauses dealing with charitable gifting reflect the testator’s wishes and produce the most tax efficient results.

Which charitable gifting clause should I use?

UK charities are exempt beneficiaries for inheritance tax purposes, meaning that gifts received by them will not be subject to inheritance tax. When a testator leaves residuary gifts to both exempt beneficiaries and non-exempt beneficiaries is it important to consider how the inheritance tax liability is to be shared amongst these beneficiaries.

The first option is to insert a clause directing that the shares of the residuary estate will be divided before inheritance tax is calculated. This will result in the non-exempt beneficiaries, usually family members, receiving a smaller share of the net estate.

The second option is to insert a clause directing that the shares of the residuary estate are to be divided after inheritance tax is calculated. Whilst this option is more complicated and increases the amount of inheritance tax payable in total, it is ultimately more favourable for the non-exempt beneficiaries.

The worked example and tables below show how the clauses can affect the distribution of the estate.

It is important to note that this is only relevant where the gift to charity is a share of the residue. If the gift is instead a fixed legacy (eg £10,000), then this will not be an issue.

Worked example

Benjamin dies leaving an estate worth £1 million. He benefits from the full nil rate band of £325,000 being the amount potentially available on which inheritance tax is payable at 0%. He leaves 4% of the residue of his estate to Cancer Research and the rest of his estate in equal shares to his three children Amy, Bethany and Callum. His estate is charged at 40% for inheritance tax purposes. There are no legacies in the Will, nor is any residence nil rate band available.

Option 1 – division before tax

The net estate is worth £1 million. The gift to charity worth £40,000 is deducted leaving £960,000. The full nil rate band of £325,000 is deducted leaving £635,000. This sum is multiplied by the inheritance tax rate of 40%, leaving an inheritance tax payment of £254,000 which is to be borne by the non-exempt beneficiaries only.

RecipientShare of residuary estateShare as a %
Bethany£235,333 23.5%
Callum£235,333 23.5%
Cancer Research£40,0004%

As can be see, the charity receives exactly 4% of the £1 million (ie before inheritance tax is deducted).

Option 2 – division after tax

The net estate of £1 million is subject to a grossing up calculation, which ultimately results in inheritance tax payable of £258,130 to be shared amongst the non-exempt beneficiaries.

RecipientShare of residuary estateShare as a %
Bethany£237,398 23.7%
Callum£237,398 23.7%
Cancer Research£29,6753%

This example demonstrates that Option 2 can result in the non-exempt beneficiaries receiving a larger share of the estate compared to when Option 1 is used. However, Option 2 does result in a greater inheritance tax bill overall, and a lesser share of the residuary estate being received by the charity. The charity does still receive 4% of the residue in Option 2, but it is 4% of the residue after deducting inheritance tax. Hence rather than receiving 4% of £1,000,000 (Option 1), the charity receives 4% of £741,870 (ie £1,000,000 minus £258,130). In this particular example, that happens to equate to 3% of £1,000,000.

It is clearly important to discuss the operation of these clauses with the testator and the effect that this may have on the division of inheritance tax liability upon their death. They may have specific views about how the inheritance tax should be calculated, paid and amounts received by charitable and other beneficiaries.

In both cases, the above tables reflect the position after deducting only inheritance tax. In reality, there will also be post-death administration costs to deduct – not to mention post-death changes in asset values etc.

Reduced rate of inheritance tax

If a testator is considering leaving a gift to charity in their Will, it is also worth considering how much of their estate they wish to leave to charity. Broadly speaking, an estate can be charged at a reduced rate of inheritance tax of 36% rather than the usual 40% if the testator leaves 10% or more of the their estate to charity (although in reality, the calculation is much more complex than that). This can be done via a share of the residue, or a specific legacy, to charity (or a mixture).

But at what point does it become more efficient to gift a larger share of the estate to charity to benefit from the reduced inheritance tax rate? By efficiency, we mean benefitting both the non-exempt and the exempt beneficiaries.

Clearly, any increase in the value left to charity will be of benefit to the charities, whilst also reducing the amount of inheritance tax payable (ie because of the inheritance tax exemption). But such an increase will not necessarily be of benefit to the non-exempt beneficiaries – it potentially could leave them with less. An increase will only be efficient for them if their share also increases.

The potential ‘tipping point’ is at 4%, meaning that if the testator has already left 4% of their estate to charity in their Will, it might be more efficient to increase the gift to 10% of the value of the estate in order to make use of the reduced inheritance tax rate. If the testator has left less than 4%, or more than 10%, of their estate to charity then any further increase will disadvantage the non-exempt beneficiaries (regardless of the inheritance tax saved). But if the percentage is between 4% and 10%, consideration should be given as to whether to increase it to 10%.

Fortunately, such consideration does not necessarily have to happen prior to death. The beneficiaries, in conjunction with the executors, could give their consent to vary the position (eg to increase the share to 10%) within two years of death. This will allow for exact calculations to be undertaken, in order to ascertain whether or not such an increase would be efficient.

How Moore Barlow can help

Here at Moore Barlow, we are able to advise you on all aspects of Will drafting including charitable gifting. Contact our expert team today.