Using Bare trusts for education fees
For grandparents who are financially secure, gifting money to your grandchildren is one of the most efficient ways of avoiding inheritance tax. However, you may be reluctant to make substantial outright gifts of capital, due to the loss of control and practical concerns about your grandchildren’s a young person’s lack of financial experience and emotional immaturity.
Risk of early access to the funds
With incorrect planning there is a risk that once the grandchild reaches the age of 18, they will have full access to the funds. If you gift assets into a discretionary trust this enables you to ensure the trustees appointed will be able to hold those assets for the benefit of your grandchildren and to distribute those assets in the appropriate circumstances, often in accordance with a Letter of Wishes which you draw up with your advisers before inception of the trust.
However you need to understand the tax implications of this planning.
- IHT should not be payable when the gift into trust is made, as long as the value of the gift is below your available nil-rate band for IHT purposes. Two grandparents can of course set up two trusts.
- The current IHT limit is £325,000 (frozen until 2017/2018) and provided you survive seven years from the date of the gift, its value will not form part of your estate for IHT purposes.
- If you were to die within seven years of making the gift, its original value would be taken into account when calculating the IHT due on death.
In addition, on every 10th anniversary a tax review takes place. A tax charge of up to 6% may arise on the value of the trust assets that are greater than the nil-rate band at the time of review. Furthermore, an exit charge may also apply where distributions have been made to the beneficiaries.
In gets worse. HMRC will probably implement a single ‘settlement’ nil-rate band. The new rules would mean that each settlor of a discretionary trust is entitled to a single ‘settlement nil-rate band’ (SNRB) separate from and unconnected to their personal nil-rate band.
They will decide how their SNRB is to be allocated between the settlements they create. HMRC has also proposed a standard 6% tax rate to be used in the calculation of 10-year and exit charges.
We used to advice clients to set up separate trusts on separate days to avoid the 10 year anniversary charge and reduce the 6% charge and now this will not be possible for any new trusts.( This does not mean trusts should not be used as the overall savings vastly exceed the likely tax charges.)
These new proposals have led to suggestions that the use of direct gifts may once again become a more favoured tax planning solution.
Bare trusts, also known as absolute trusts, are the simplest form of trust. Any gift into a bare trust is classified as a potentially exempt transfer (PET) for IHT purposes. As long as you survive for seven years from the date of the gift, it falls outside of your estate. A further benefit is that it will also not be subject to the IHT considerations associated with discretionary trusts.
A bare trust is highly transparent for income tax and capital gains tax purposes with the trust’s income and gains assessed directly on the beneficiary rather than the creator or trustees of the trust ( as in the case of discretionary trusts).
This will be the case unless a parent creates the trust, in which case the income that arises is treated as the income of the parent if it is paid to, or for the benefit of, an unmarried minor child of the parent.
Parental settlement rules
The so called ‘parental settlement rules’ only apply to trusts where a minor child can benefit from the trust and the donor parent is excluded. The rules do not apply once a child beneficiary becomes 18 years of age.
However the parental settlement rules do not apply to trusts set up by grandparents – or indeed anyone else – in which case any income paid to the child will be taxed as income of that child.
This can be particularly effective tax planning for grandparents wishing to assist with school fee planning for their grandchildren as well as benefiting from favourable IHT treatment.
The main concern with Bare trusts
The main concern with such trusts is the fact the beneficiary will be immediately entitled to the trust assets on attaining age 18, can legally call for the asset to be transferred into their name. In the real world this is of course unlikely.
What is of concern is the fact the beneficiary is absolutely entitled to the funds also means that unlike discretionary trusts the bare trust offers no protection of the funds from any third parties, for example in the event of divorce or bankruptcy. Again however if he trust have been set up for education fees very few people go bankrupt or get divorced before the finish their university education.
Bare trusts suitable structures
Suitable structures can be drafted specifically so as to not enable your grandchild access until a specific age as determined by you the grandparent, but to also allow some access prior to that age for certain events such as facilitating school and university fees.
Estate planning is a very complex area and different solutions will suit different clients. Experienced help and advice is essential before any action is taken in this area.