In brief:
- The IHT treatment of a gift in a will can turn on a single word of drafting.
- Two conflicting lines of case law produce very different outcomes, which applies depends on construction.
- The financial consequences between beneficiaries can be significant and are often overlooked.
When drafting a will, one significant consideration is the inheritance tax (IHT) treatment of gifts made to different categories of beneficiary.
Gifts to a spouse or civil partner are typically fully exempt. Gifts to qualifying charities are likewise exempt, and where at least 10% of the net estate passes to charity, the IHT rate on the remainder reduces from 40% to 36%. Children, grandchildren, siblings, unmarried partners, and friends receive no such exemption.
When the residue is divided between both exempt and non-exempt beneficiaries. Two distinct principles emerge from the case law.
In Re Benham, "division after tax", the IHT is calculated on a grossed-up basis where IHT is spread across all beneficiaries to equalise the net distribution. This results in the estate facing a higher IHT burden.
In Re Ratcliffe, "division before tax", the court adopted a different approach: the residue must be divided before tax with the full IHT burden falling on the non-exempt beneficiaries. This method results in a lower IHT liability.
The distinction is not merely academic; it can represent a significant difference in the sums received by each beneficiary. Which principle applies depends on the construction of the will's residuary provisions.
IHT calculations can be further complicated by legacies in a will. A testator may direct that a legacy is to be paid free of tax, meaning the IHT attributable to that gift is to be borne by the residuary estate rather than the legatee. Whilst this achieves the testator's aim of ensuring the beneficiary receives the full intended sum, it carries significant consequences for the residuary estate.
Where a legacy is expressed as free of tax, the legacy must be grossed up to calculate the true taxable value. This is because the estate is bearing an additional cost, the IHT on the gift, which must itself be brought into account for IHT purposes. The grossing-up calculation increases the notional value of the gift, which in turn increases the overall IHT liability of the estate.
Where the residue is partly exempt, the grossing-up exercise becomes particularly complex; the tax attributable to the non-exempt legatee must be apportioned across the whole residue, while the tax due on the non-exempt share of residue is only on that part. Careful drafting is therefore essential to avoid unintended consequences between beneficiaries.
Given the complexity, professional legal advice is indispensable to achieving the testator's intended distribution in a tax-efficient manner.