The perks and pitfalls of testamentary charitable giving

The government's reforms to the inheritance tax (IHT) regime announced earlier this year, with the introduction of
a new main residence nil-rate band, have once again put IHT under the spotlight. At the same time, recent figures show revenue derived from IHT to be at a five-year high.

While the latest reforms could help ease the tax burden of many estates, sensible estate planning should still be encouraged at an early stage, especially as this new relief will taper away. For net estates over £2m the residence nil-rate band will be withdrawn at a rate of £1 for every £2 over the threshold.

Estate planning can be achieved through a number of means, including regular lifetime giving, but what is often not given enough weight or consideration is the use of charitable legacies.
It is well known that all lifetime and testamentary gifts to charities are IHT exempt. Significantly, where these charitable legacies are substantial enough, the rest of the estate can benefit from
a reduced IHT rate.

IHT reduction

Where at least 10 per cent of the baseline
amount (calculated with reference to the various components of the estate and any relevant reliefs and exemptions) is left to charity, the whole of the taxable estate will be taxed at 36 per cent rather than 40 per cent ('the 10 per cent rule').

This does not mean that charitable legacies
can be used to mitigate IHT to such an extent that
other non-charitable beneficiaries receive a larger inheritance than they would do if there were no charitable legacies. The reduced rate of IHT applied to the remaining estate, however, helps to compensate the estate and offsets some of the sum given to charity.

On a simple net estate of £2m, assuming there is a full nil-rate band of £325,000 and no other reliefs, such as business property relief or agricultural property relief, are available, the taxable estate (or chargeable transfer) would be £1,675,000. IHT at a rate of 40 per cent would be £670,000, leaving the beneficiaries with £1,330,000 (before other considerations such as administration costs).

If, however, a legacy of £167,500 (10 per cent of the baseline amount of £2m, less the nil-rate band of £325,000) had been left to charity, the taxable estate would be £1,507,500, which, taxed at 36 per cent, would result in IHT of only £542,700. The non-charity beneficiaries would, therefore, be entitled to £1,289,800 between them (£2m, less IHT of £542,700 and the charitable legacy of £167,500).

While £1,289,800 is certainly lower than £1,330,000, it represents a reduction for the non-charity beneficiaries of only £40,200, to be weighed against a benefit to charity of £167,500. The potential of these proportionate savings to
the estate means that all solicitors looking at estate planning should at least consider discussing the possibility of utilising the 10 per cent rule with
their client.

Where a client expresses a wish to leave a significant sum to charity, it is vital that the
10 per cent rule is considered. There may even
be scenarios where a solicitor who fails to advise
a client about the rule could face a negligence claim from the estate's beneficiaries, because the 10 per cent rule functions as a cliff edge.

Where the testator leaves less than 10 per cent to charity, the estate will still be taxed at the full 40 per cent. In our example estate, leaving 9 per cent to charity would leave the non-charity beneficiaries with £1,239,550: £50,250 less than if an extra 1 per cent had been left to charity. In fact, any charitable legacy above 4 per cent of the baseline amount will cost the non-charitable beneficiaries more than a 10 per cent legacy. The obvious conclusion if the client is considering a charitable gift of between
4 and 10 per cent of their estate is that it is essential to consider whether it might be more tax efficient to increase the charitable legacy.

Effective gift

In most estates, the calculation of what represents 10 per cent is more complex than these examples, and to ensure that an estate benefits from the reduced rate, it is crucial that the will makes provision for a legacy which complies with the
10 per cent rule. It is also important to ensure that the will is drafted in such a way that the charitable gift is effective. The terms of the gift should be as flexible as possible to ensure that the charity is able to use the funds as the testator intended. If the funds cannot be applied towards the charity's purposes, the gift to the charity could fail, meaning that any intended IHT savings are lost and the charity cannot benefit from the gift.

With the best of intentions, some testators
place conditions on the charitable gift that
cannot be fulfilled at the date of the testator's death. This can also be problematic for a charity where the conditions can be met but adhering
to them creates an administrative burden, which clearly would not be what the testator would have intended. Instead, a legacy expressed to be for general purposes, coupled with a letter of wishes setting out the testator's preference for the use of the legacy, would overcome this potential obstacle.

The structure of the charitable gift is also an important consideration. In a fluctuating economic climate, gifts such as permanent endowments can be difficult for a charity to administer as the charity can only access the income produced by the capital sum. The charity has a duty to maintain the value of the capital, and in cases where the income is reduced due to external factors in financial markets, the charity itself sees very little benefit from the gift, which would surely not be the testator’s intention either.

There are powers under the Charities Act 2011 which enable charities to break certain permanent endowments in order to utilise capital, but this involves a lengthy and costly process for the charity. Full consideration of the testator’s intentions is always vital, but equally important is that the professional advice provided to the client must contemplate the practicalities of implementing the terms of the gift to the charity.

In cases where charitable gifts fail because the wording of the gift is void for uncertainty or impossibility, there are also rules which the court may apply to save the gift. The doctrine of cy-près means that if a charitable gift or trust fails for certain reasons (for example, due to poor drafting), the gift can be applied and used for other purposes that are as near as possible to those expressed. Since the Charities Act 2011, the Charity Commission and the courts have extensive powers to deal with donations that cannot be applied as originally intended. In the case of a charitable legacy contained in a will, if for example a charity has merged with another charity, or is not in existence at the date of the testator’s death, the funds may be applied for alternative charitable purposes via the doctrine of cy-près.

Naturally, not all clients will want to give charitable legacies, and doing so may not be appropriate for all estates. If they do, however, the potential IHT savings to their estate can be significant and careful consideration must be given to the appropriate level of charitable gift following a detailed assessment of their assets (including those held in trust). The same careful consideration must equally be given to the drafting of their will in order to ensure that the clients’ wishes are fully implemented and effective. SJ

Amelia Beringer, pictured, and John Fitzgerald are solicitors at Gordon Dadds