If your estate is worth over £325,000 when you die, Inheritance Tax may be due. From 6 April 2012, if you leave 10 per cent of your estate to charity, the tax due may be paid at a reduced rate of 36 per cent instead of 40 per cent.
How the reduced rate works
Gifts you make to a “qualifying” charity – during your lifetime or in your will – will be exempt from Inheritance Tax.
In order to qualify for the reduced rate, you must leave at least 10 per cent of the net value of your estate to a qualifying charity.
The net value of your estate is the sum of all the assets after deducting any debts, liabilities, reliefs, exemptions and the nil-rate band.
A qualifying charity is an organisation that is recognised as a charity for tax purposes by HM Revenue & Customs. There are different ways that you can own assets; the way that you own those assets and with who affects the way they are treated when deciding whether the reduced rate of tax can apply.
To see how much you need to leave to charity to qualify, or whether your estate can pay a reduced rate of Inheritance Tax because of a charitable donation left in a will, you have to work out the value of each of the separate parts of your estate. These are known as “components”. It's possible that one part of your estate may pay Inheritance Tax at 36 per cent and another pay tax at the full rate of 40 per cent.
To work out whether the reduced rate applies, your estate and your assets are broken down into three components as follows:
- Assets that you own jointly with someone else that pass by “survivorship”
- Assets held in trust
- Assets that you own outright or as tenants in common with someone else
It's also possible to merge one or more components to gain the maximum benefit from the reduced rate.
Assets to watch out for...
Any assets that are classed as joint assets passing by survivorship, or “gifts with reservation of benefit”, will only qualify for the reduced rate if they are merged with another component that qualifies for the reduced rate of Inheritance Tax.
Calculating the reduced rate Inheritance Tax – some examples
Example 1 – One estate component
Robert died on 17 June 2012 leaving a net estate valued at £750,000. He leaves £50,000 to the National Trust in his will.
- £750,000 - £50,000 (donation) = £700,000
- £700,000 - £325,000 (Inheritance Tax nil rate band) = £375,000
- £375,000 + £50,000 (donation) = £425,000 – the “baseline amount”
This estate qualifies for the reduced rate of Inheritance Tax because the charitable donation of £50,000 is more than 10 per cent of the “baseline amount”.
The Inheritance Tax payable will be £135,000 compared to £150,000 if Inheritance Tax was paid at the full rate.
Example 2 – Two estate components
Elizabeth died on 17 May 2012 leaving assets owned personally of £750,000. Her will stated that she wanted to leave 10 per cent of her assets to Cancer Research.
She held a joint bank account with her son Andrew, which had a balance of £60,000 at death. Both contributed equally to the account so her estate also had joint property assets passing by survivorship of £30,000.
The estate therefore contains a survivorship and a general component. The charity donation in the general component is £75,000.
- £750,000 - £75,000 (donation) = £675,000
- £675,000 + £30,000 (survivorship component) = £705,000
- Apportion the nil rate band between the two components: £675,000/£705,000 x £325,000 (Inheritance Tax nil rate band) = £311,170
- £675,000 (step 1) - £311,170 = £363,830
- £363,830 + £75,000 (donation) = £438,830 – the “baseline amount”
10 per cent of £438,830 is £43,883. The general component of Elizabeth's estate therefore qualifies for the reduced rate because she donated £75,000.
The reduced rate of Inheritance Tax means that the estate will only pay £130,978.80 compared to £145,532 if it had to pay at the full rate.
The joint account passes by survivorship to Andrew, so this component cannot qualify for the reduced rate.
Where the amount qualifying for charity exemption in one component passes the 10 per cent test, the beneficiaries of the estate may choose to elect to merge with other estate components to gain the maximum benefit from the reduced rate. The following calculation shows how this can work based on the previous example.
10 per cent of the baseline amount for the general component of Elizabeth's estate was £43,883. So the £75,000 actually being given to charity was more than was needed to qualify for the reduced rate of tax. It may be possible to elect to merge the survivorship component with the general component of Elizabeth's estate so that the reduced rate of tax applies to both components.
The following calculations show whether the merged components would qualify for the reduced rate of tax.
- £30,000 (the survivorship component) + £675,000 (general component) = £705,000
- £705,000 - £325,000 ( the nil rate band) = £380,000
- £380,000 + £75,000 (donation) = £455,000 – the “baseline amount”
10 per cent of £455,000 is £45,500. The merged components of Elizabeth's estate therefore qualify for the reduced rate as the donated amount of £75,000 is more than 10 per cent of the baseline amount.
Writing your will to leave assets to charity
To avoid the need to continually revise the amount of charitable donations written into wills, it is possible to include a clause to ensure that it will always meet the ten per cent test.
Varying a will after a death
If you haven’t left assets to a qualifying charity or if the donation in your will doesn't pass the 10 per cent test when you die, the beneficiaries of your estate can execute a Deed of Variation to make or increase a donation to charity. Doing so may mean that your estate can then qualify to pay Inheritance Tax at the lower rate.