WillsResiduary Estate: Exempt and Non-Exempt Beneficiaries

Estates with an inheritance tax (IHT) liability are becoming increasingly common; therefore, it is becoming more important to ensure that every possible outcome has been considered where IHT is concerned. The usual consideration given is what will preserve and fully utilise the transferrable nil-rate band (TNRB) and residence nil-rate band (RNRB) and whether a late spouses nil-rate band (NRB) has been used and to what extent.

The way a will has been drafted can have an impact on how IHT is dealt with and the distribution of the estate once this has been taken into consideration. In this article, we are going to look at how the will can be drafted to ensure that the testator’s wishes are met with regards to the burden of IHT where the residuary estate contains exempt and non-exempt beneficiaries.

Who are exempt and non-exempt beneficiaries?

First, we need to establish who the exempt beneficiaries are. These are any of the following:

• A Spouse or Civil Partner.
• Registered UK charities.
• Qualifying political parties.
• Some national institutions, for example museums.

Any gifts to these beneficiaries will nearly always be free of IHT. However, if a beneficiary is does not fall into any of the above categories, for example children, then gifts to them will be subject to IHT.

What needs to be considered?

If an estate is not likely to have an IHT liability, then no further consideration is needed. However, if an estate is likely to incur IHT charges and  there are mixture of exempt and non-exempt beneficiaries under the residue of the estate, then the client should be made aware that they can decide whether the distribution sum can be either before tax is paid, or after tax is paid.

For example, if Mrs Jones decided to divide her residuary estate; 90% between her children and the remaining 10% to a charity. Her estate is valued at £1.2m. This creates a situation of exempt and non-exempt beneficiaries being included as beneficiaries of her estate and with an IHT liability to consider. Leaving the will silent on this can cause issues with how the estate should be distributed when Mrs Jones dies.

Mrs Jones’ personal representatives (PRs) will need to take several steps to ascertain how she intended her estate to be distributed. These include:

• Reviewing the will and relevant case law to see if the will contains any clauses relating to this.
• Obtaining the will file for any indication of advice provided and intention shown by Mrs Jones.
• Or seek an agreement between the beneficiaries on how the distribution should take place. If the beneficiaries cannot reach an agreement, the PRs may need to apply to the court for directions.

What are the options and the effects of them?

The first and more simple option is to divide the estate before IHT. Therefore, based on the above example, the 90% that will pass to the children will be subject to IHT and will have that sum deducted from their shares, whereas the 10% to charity will not be deducted at all.

To put this into perspective, if a will divided the residuary estate equally between exempt and non-exempt beneficiaries, using this option will result in the exempt beneficiaries receiving a higher share of the estate once IHT has been paid.

The second option is to divide the estate after IHT is paid. Under this option, any IHT charges are considered and paid before the estate is distributed. This will likely be the more appealing option as the distribution appears to be more equal than the first option. However, this is a more complex option in practise that results in more overall IHT payable.

Case Law

Most sources highlight two specific cases for this issue:

1. Re Ratcliffe Holmes v McMullan [1999] S.T.C. 262 – Ultimately for this case, the shares of the estate were calculated before IHT. This case is generally followed if the intention of the testator is uncertain. Following this case is usually the more favourable option for a testator and exempt beneficiaries.
2. Re Benham’s WillTrusts (1995) STC 210 – In this case, the distribution of the estate was calculated after IHT. This is not a favourable option for a testator due to the IHT consequences, but non-exempt beneficiaries may wish to pursue this because of the more equal distribution after IHT.