Making the most of the 36 per cent IHT rate

The planning potential
of the lower rate of inheritance tax (IHT), introduced in 2012, has often been under estimated. Two key issues are variations within two years of death and merger of components.

The first variation is calculated by deducting 10 per cent from the ‘baseline amount’. You deduct from the net estate any available nil rate band (NRB), all exemptions and reliefs, apart from the charity itself, to find the baseline amount.

For example, Alice dies leaving an estate of £575k with £20k going to charity and the rest to a nephew, Peter. The baseline amount is £250k after deducting £325k NRB. The £20k is only 8 per cent and fails the 10 per cent test above. If Alice had left £25k to charity it would have reduced the IHT on the residue by £11k, increasing the net estate by £6k as well as increasing the charity legacy
by £5k.

In the above example, if Peter varied the will within two years of Alice’s death to increase the legacy to £25k, he could save himself a significant amount, even after paying his solicitor to draft the deed of variation. All, except HMRC, are winners. What are the lessons to be learned?

• Many estates’ gifts to charity are insufficient to meet the 10 per cent test.
• If 4 per cent of the baseline amount is left, it can be increased to 10 per cent and the net estate is unchanged.
• If more than 4 per cent is left, but less than 10 per cent, increasing to 10 per cent will increase the net estate.

Where the charity gift amounts to between 4 per cent and 10 per cent, we can and, arguably should, advise residuary beneficiaries that increasing the charity gift could leave them better off. If it amounts to exactly 4 per cent, advise they could increase the charity gift with no loss to the estate – only the deed of variation costs. Last, if it is less than 4 per cent, there is still an opportunity for giving to charity very tax effectively, saving the
40 per cent IHT and reducing
the IHT rate to 36 per cent, significantly cutting the cost
of the gift.

At the very least, people may appreciate the advice, and you have ‘covered your back’, but they may be so impressed you gain a new client.

Merging component parts

The 10 per cent test is applied to three component parts:

• the survivorship component: all the property owned as joint tenants, which passes by survivorship, disregarding any severance effected by a variation;
• the settled property component: all the trusts in which the deceased had a life interest, which are taxable with the estate on death; and
• the general component: all the rest of the taxable estate apart from any assets in which there is a reserved benefit.

An election can be made to merge a qualifying component, which has more than the 10 per cent, with a non-qualifying one. If the merged component then satisfies the 10 per cent test,
the 36 per cent rate can apply
to it all.

If an estate has an ‘excess’ of charity gifts, the personal representatives (PRs) can bestow the benefits of merger on another component. If there is an excess in a trust, the trustees (of all the trusts, if more than one) can bestow the benefits on the estate or the survivorship component.

If you were acting for the PRs of an estate that did not qualify, but the deceased was the life tenant of a single trust which passed on death to charity, you’ll know the trust has charity gifts of 100 per cent, with clearly a large surplus to share.

If the charity gift is more than 10 per cent of the baseline amount for the combined estate and trust, you could propose to the trustees a merger of the settled property and general components. If the two or more trusts were aggregable with the estate for IHT, all the trusts would be in the settled property component, merger would be with the whole component and the trustees of all the trusts would need to join in.

The trustees would have nothing to gain from merger, so the PRs would need to indemnify them from any costs, and any loss, and hope they would see the benefit of helping the beneficiaries of the deceased life tenant, even though not to the benefit of the charity reversionary beneficiary. For further details of process, see
the Inheritance Tax Manual
IHTM 45000.

We need to keep our eyes open for such situations, as
the benefit can be significant, and overlooking it could be serious. SJ

John Bunker is head of private client knowledge management at Thomas Eggar