Where a residuary estate includes both exempt and non-exempt beneficiaries, it is essential that the will clearly sets out how the inheritance tax (IHT) burden is to be shared. In the absence of express wording, personal representatives (PRs) may face uncertainty and potential disputes. This article outlines the key principles and offers practical drafting guidance for wills in these circumstances.
Exempt and Non-Exempt Beneficiaries: A Recap
Under the Inheritance Tax Act 1984 (IHTA 1984), certain gifts are exempt from IHT, including:
- Spouses and civil partners (section 18)
- UK registered charities (section 23)
- Qualifying political parties (section 24)
- Certain national institutions (e.g., some museums and galleries)
If a gift is exempt from IHT, none of the tax attributable to the value of the estate can be deducted from that gift (section 41 IHTA). This statutory protection cannot be overridden by the terms of the will. Gifts to these beneficiaries are generally free of IHT. In contrast, gifts to non-exempt beneficiaries—such as children, grandchildren, other relatives, and friends—may be taxable, subject to available reliefs and allowances (including the nil rate band, residence nil rate band, and business or agricultural relief).
Why Express Drafting Matters
Where a will divides the estate between exempt and non-exempt beneficiaries, it is vital to specify how the shares are to be distributed in light of the IHT position. No IHT can be applied to the shares of exempt beneficiaries, so the drafting must make clear how the tax burden is to be allocated.
Two key cases have considered this issue, where estates were divided between mixed beneficiaries and it was unclear whether the division should be before or after IHT:
- Re Ratcliffe Holmes v McMullan (1999) STC 262
- Re Benham’s Will Trusts [1995] STC 210
These cases provide two possible approaches:
- Before tax division: Each beneficiary’s share is calculated before IHT. This is the most straightforward approach but it will mean that exempt beneficiaries will recieve proportionately more than non-exempt beneficiaries who will pay IHT on their share. This was the approach in Ratcliffe
- After tax division: Shares are calculated after IHT is paid. This is a more complicated option as a grossing up exercise is needed to ensure S41 IHTA is not breached. This increases the before tax shares for non-exempt beneficiaries, and is therefore more favourable to them. It will however will result in a higher IHT bill and will be more complex for the executors to administer due to the grossing up calculation, This was the approach in Benham.
When the Will is Silent
If the estate is divided between mixed beneficiaries and does not specify which approach to use, the PRs will need to review the will and case file for interpretive clues or to ascertain the testator’s intention. Alternatively, they may seek agreement among all residuary beneficiaries on how to distribute the estate. If an agreement cannot be reached, the PRs may need to seek directions from the court.
Drafting Options
While a testator may prefer the Benham approach for on the basis of fairness, this will increase the IHT bill. It will also give the executors an additional burden of grossing up the non-exempt beneficiaries shares. If lay executors are appointed, they will likely need to incur additional costs to the estate for professional assistance.
If the testator wishes to benefit from the reduced IHT rate of 36% (where 10% of the net estate is left to charity), it is generally easier to achieve this using the Ratcliffe approach.
If the Ratcliffe approach is chosen, the testator could consider increasing the shares of non-exempt beneficiaries to reflect the IHT they will bear, though this will also increase the overall bill.
Whichever approach is adopted, it is advisable that clear and explicit wording be included in the will.
Alternatives
Other options may be suitable where a client wishes to benefit both exempt and non-exempt beneficiaries. For example, fixed gifts could be left to exempt beneficiaries, with the residue passing to non-exempt beneficiaries (or vice versa). This avoids mixing exempt and non-exempt beneficiaries in the residue, though it may be difficult to determine the appropriate size of fixed gifts as the size of the estate may change.
Alternatively, the estate could be left to a discretionary trust, guided by a letter of wishes. Care must be taken to ensure distributions are made within two years of death to benefit from the reading back rules under section 144 IHTA.
Conclusion
Ultimately, the division of IHT between exempt and non-exempt beneficiaries is a technical area where precise drafting is invaluable. By addressing this issue directly in the will, testators can ensure their wishes are respected and the administration of their estate proceeds smoothly.
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