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Tax Doctor: How can I qualify for the reduced IHT rate?

Tax Doctor: How can I qualify for the reduced IHT rate?

The case

My mother died in June this year and I am involved in sorting out her estate. I have heard there is a reduced rate of inheritance tax available, determined by the amount left to charity.

My mother’s estate consists roughly of her house (worth £500,000), investments (worth £250,000) and chattels (worth £100,000). Under the terms of her will, a legacy of £30,000 is to go to various local and national charities, with the remainder to me and my sister in equal proportion.

My parents were divorced at the time of my father’s death, so there is no transferable nil-rate band.

I don’t think a sufficient amount is left to charity to trigger the reduced rate, but I wondered whether anything could be done to benefit from that rate.

The prescription

The inheritance tax (IHT) rate of 40% is reduced to 36% for deaths after 6 April 2012 where people leave a charitable legacy of at least 10% of a component of their net estate when they die.

There are three components: the free estate, jointly owned assets passing on survivorship and settled/trust property being aggregated with the deceased’s estate. In your query you have not mentioned any trust interest. Assuming the house was in your mother’s sole name, it appears there is just the free estate to consider.

If that is not the case, the position for each component would need to be considered independently, regarding its related charitable legacies as to whether the 10% baseline is reached. However, it is possible to elect for components to be combined to arrive at an aggregated baseline.

A quick calculation

Your mother’s estate totals £850,000. Deductions are made for any reliefs, exemptions and the available nil-rate band. No mention is made of any assets qualifying for any IHT reliefs other than the charitable legacies, which are ignored for this purpose.

The available nil-rate band would appear to be the full £325,000, as there is no mention of any gifts in the previous seven years coming into charge and there is no transferable element from the estate of a predeceased spouse. The net estate is therefore £525,000, with a 10% baseline requirement of £52,500.

The total charitable legacies of £30,000 fall below this amount, so the £525,000, less the £30,000, will give rise to an IHT liability of £198,000 (£495,000 at 40%), leaving £622,000 for distribution between you and your sister.

A deed of variation

It is possible, within two years of your mother’s death, to restructure the legacies (partially or wholly) using a deed of variation. If the charitable legacies were to be increased by £22,500 to meet the 10% requirement, the reduced 36% IHT rate would be achieved.

The IHT on the £525,000, reduced by the increased charitable legacy of £52,500, would be £170,100 (£472,500 at 36%), leaving £627,400 for distribution between you and your sister. The amount distributed to the beneficiaries would increase by £5,400 and the gift to charity would increase by £22,500: a win-win situation for you and the charity.

Going down this route would require additional paperwork and administration, including evidence the recipient of the additional charitable element has been notified of the deed of variation.

A further point of consideration

While considering the deed of variation, you and your sister should also consider your financial positions. One or both of you may wish to take the opportunity to pass on some or all of your inheritance to your children, so the funds effectively skip a generation, falling into your children’s estates rather than your own.

Richard Mannion is national tax director at Smith & Williamson.

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