One Independent reader has discovered that care needs to be taken over the way trusts are set up for grandchildren to shield them from unnecessary tax.
The reader was stunned to be told that his three grandchildren, all non-taxpayers, are having to pay tax at 35 per cent on pounds 40,000 left to them in a trust set up by his late wife.
He was appointed to administer the fund and invested it in a building society. Building society interest is taxed at 25 per cent unless the account is registered to receive interest gross, something only non-taxpayers can do. The reader's grandchildren are non-taxpayers, so last year he tried to register their accounts.
'The Inland Revenue quoted me one of their rules to say that I would have to pay 25 per cent plus 10 per cent income tax, as this was a trust fund,' he said.
'In the meantime I have received a tax demand for this extra 10 per cent even on the interest received on these accounts since January 1990.
'I contacted the Inland Revenue again but they said 'tough luck'.'
Both the Inland Revenue and two accountants who were consulted say that the trust appears to have been set up with a stipulation that the income is not to be distributed to the beneficiaries.
Income rolled-up in a conventional trust is taxed at a basic rate of 25 per cent plus an additional rate of 10 per cent.
'If the will states that income in the trust is to roll up there is nothing you can do about it,' said Andrew Burgess, director of tax consultancy at Neville Russell, the accountants.
If the trust had been arranged so that income from the money was handed over to the children, they would avoid paying tax on it for as long as they were non-taxpayers. Children have the same annual personal allowance as a single adult, currently pounds 3,445.
There is one type of trust which offers a solution if grandparents really do not want the children to be able to touch income from their inheritance. This is the 'bare' trust in which income can be rolled up without being taxed as long as the beneficiary is a non-taxpayer.
The disadvantage is that legally the money is owned by the child, so theoretically he or she could get hold of the capital at any time. But Mr Burgess said that the trustees would normally be able to exercise control.
Moira Elms, manager of the personal finance group at Coopers & Lybrand Deloitte, said a bare trust was usually an effective way for grandparents to set money aside for children.
'For an amount like pounds 40,000 split between three children we would probably recommend a bare trust,' she said.
'Bare trusts are simple to set up but you should take some advice from a solicitor or an accountant.'
Parents can also give money to their children through a bare trust and avoid having the income taxed at their own rate.
There is an element of uncertainty over the future of bare trusts. The Revenue has hinted that it is not keen on them, because of their tax advantages.
The main disadvantage with a bare trust is that children have a right to receive the money when they are 18.
'If grandparents do not want the children to have access to the money then they would probably want to go for an accumulation and maintenance trust,' said Ms Elms.
This is a type of discretionary trust. But with an ordinary discretionary trust, the trustees have great control over when money is passed to the children, whereas an accumulation and maintenance trust can be set up with strict stipulations to determine when the capital is paid.
Money paid into an accumulation and maintenance trust can also avoid inheritance tax (IHT), if a grandparent lives for seven years after handing the money over.
Neville Russell can supply a free leaflet on trusts. Write to Andrew Burgess at 37 Frederick Place, Brighton, East Sussex BN1 4EA.
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