One of the most tax effective ways of giving is by skipping a generation; in other words, grandparents making a gift to their grandchildren. However, it is quite likely that the grandchildren are too young to receive large sums of money or they may not be financially responsible. The alternative is to use a trust, so that the trustees can manage the money on behalf of these young grandchildren.
Perhaps the most suitable trust in these circumstances is an "accumulation and maintenance trust". Assume Mr and Mrs Smith have four grandchildren aged between two and 10. They decide to set up an accumulation and maintenance trust for the grandchildren's benefit. The terms of the trust would be that, until a grandchild reaches the age of 25, he or she has no entitlement to either the income or the capital from the trust. Any distribution would be at the trustees' discretion. The initial trustees would be chosen by Mr and Mrs Smith (and there is no reason why they should not retain the power to appoint new trustees in the future). The trustees could be Mr and Mrs Smith themselves, their children, their professional advisers or any combination of these people. The number of trustees cannot exceed four and two or three is usually the best number.
Having set up the trust, Mr and Mrs Smith transfer a sum of cash to it. Provided they survive for seven years from the date of the gift, then it will be no longer relevant for calculating inheritance tax on their deaths. If the gift was pounds 100,000 then this would represent an inheritance tax saving of pounds 40,000. There is also a further advantage. The value of the gift is taken at the date when it is made. Therefore, if the pounds 100,000 has been invested wisely it may well have increased in value but all that increase in value would be outside Mr and Mrs Smith's estates.
The trustees invest the pounds 100,000 and receive the dividend income on which they are liable to income tax at 34 per cent. This income can either be accumulated within the trust or used to benefit any one or more of the grandchildren. If it is used to benefit the grandchildren, there can also be an income tax advantage. Let us assume that the trust generates pounds 3,000 of gross income per year and the trustees decide to distribute this to John, one of the grandchildren. The position would be as follows:
Trustees receive gross income of pounds 3,000 Trustees pay income tax at 34 per cent pounds 1,020 Trustees pay balance to John for school fees pounds 1,980
As John has no other income and the income received from the trust is within his personal allowance, he (or at least his parents on his behalf) can reclaim all the income tax paid so that he will get the pounds 1,020 back. This means that instead of the income being taxed at Mr and Mrs Smith's rate of income tax, it will be taxed at John's own rate which in this case is nil.
Until John is 25, the trustees can continue to make decisions on how much income he will receive. When he reaches 25, and assuming that there are still four grandchildren, he would become entitled to either the income from a quarter of the trust fund or to a quarter of the trust fund outright (it would depend on how the trust has been written).
There is also a marginal capital gains tax advantage with the creation of the trust, assuming that Mr and Mrs Smith would be liable to capital gains tax at 40 per cent. The trust is liable to tax on gains at 34 per cent and, as it is the only trust created by Mr and Mrs Smith, it will have its own capital gains tax annual allowance of pounds 3,150. If Mr and Mrs Smith wished to add to the trust then of course they could do so. This does not need to be by adding large sums of capital, but could be by using each of their inheritance tax annual allowances of pounds 3,000.
If the grandchildren are past school age, but still not felt to be totally responsible with the large sums of money that they may become entitled to, then rather than use an accumulation and maintenance trust it might be appropriate to use an "interest in possession trust". Again, assuming that there are four grandchildren, the trust would have four funds, one for each of them. Each would be entitled to the income generated by his or her fund. The trustees would continue to manage the capital and, if one of the grandchildren wanted help with the deposit on a house or needed some assistance with a small business venture, then the trustees could decide whether they wanted to assist in that way. When the trustees felt that each grandchild was responsible with money they would distribute the share to that grandchild.
The inheritance tax advantages of making an interest in possession trust are exactly the same as for the accumulation and maintenance trust mentioned above. The income generated by the trust assets and paid to each of the grandchildren will be treated as the grandchildren's own income and taxed at their rates of tax. The trust will have a capital gains tax annual exemption of pounds 3,150 and, in addition, gains will only be taxed at 24 per cent. Therefore, for larger sums of money, where there may be an actively managed portfolio, an interest in possession settlement might be a better option n
The author is a partner at Lawrence Graham, Solicitors.Reuse content