If parents give their children money or assets that produce income in excess of £100, all the income will be taxable on the parents. Cash or assets provided by grandparents do not suffer this problem, so it is possible for grandparents to provide funds to children who can then use their own personal allowance and lower rate tax bands.
Historically, trusts were used provide income for children in a controlled environment until they were old enough to manage their wealth responsibly. Up until 2006 it was possible to set up an Inheritance tax advantaged trust fund for grandchildren. This could be used to pay school or university fees and other expenses up until they reached 25 years of age.
However, in 2006 major changes were made to the taxation of trusts, so we have had to find alternative ways to help fund their start in life.
Bare Trusts
It is still possible to use Bare Trusts. Also known as Simple Trusts, these give each beneficiary an immediate and absolute right to both capital and income. The beneficiary is taxed on the trust’s income and gains as they arise and is entitled to the assets at 18.
A Bare Trust can be used to hold investments, for example which mature at regular intervals to pay out at times when fees become due. A bond can also be used to make use of the 5% tax-free withdrawals.
Junior ISAs
Junior ISAs replaced child trust funds as the coalition government’s choice for funding university education. Funds in a Junior ISA grow tax-free and anyone can add up to £4,000 to it in a tax year.
It is worth noting that if the funds come from someone other than the child’s parents, a regular bank account can also produce tax-free interest as the child is highly unlikely to have used their personal allowance of £10,000 elsewhere.
There is no equivalent deeming provision for capital gains tax, so parents can put assets into their child’s name and use the child’s capital gains tax annual exemption (currently £11,000) and basic rate bands. So parents may find an investment focussed on capital growth to be more appropriate than an income-producing product.
The problem with any of these investments as that when the child reaches 18 (or maybe before that in some cases) they can access the funds and spend as they see fit.
Gifts out of income
There is an exemption from IHT for making gifts out of your income. It is important that the gifts are out of income (ie gifts from capital such as the proceeds received will not qualify for relief). The gifts must be habitual and leave you in a position whereby your standard of living is not affected. A gift can be habitual the first time it is made if it can be shown that it is intended to be repeated. Examples of how this can be used are:
- Paying school fees of children.
- Setting up pension funds for your children to contribute £3,600 per annum for each of them which will be available for them when they get to 55.
- Payments into a life assurance trust.
- Funding a family trust.
Tax credits
Parents can apply for working and child tax credits, which can greatly help the less well-off meet the cost of childcare (including registered nannies). If parents with one child work at least 16 hours a week, they can get up to 70% of the childcare costs paid for, up to maximum of £175 per week (this equates to £122.50 in tax credits). Tax Credits are a means-tested benefit. Once the couple’s income goes over £6,420 per year, the tax credits are withdrawn at a rate of 41p for every £1 their income over this threshold. It is possible for those who have their own companies to take a low salary/dividend and claim tax credits.
High income child benefit charge
Child benefit is not means-tested, nor is it dependant on the parents making national insurance contributions. However since 7 January 2013 if the higher earner of the couple earns more than £50,000 per year then a tax charge arises on the higher earner, in an attempt to claw the child benefit back. The charge is calculated as 1% of the child benefit for every £100 the income exceeds £50,000. This means the child benefit is entirely withdrawn if the higher earner makes more than £60,000.
Family companies
As previously mentioned if the parent provides an asset that produces more than £100 then the income is taxed on the parent, so family companies are better suited to grandparents. Normally a grandparent funds a child’s school fees from taxed income. This would often fall within the Gifts out of income exemption for IHT but the grandparent may have suffered additional rate tax on this income.
If the grandparents own a company from which they receive salary or dividends to fund the grandchild’s school fees, they may wish to set up a trust to hold some shares on behalf of the grandchildren. If the company is a trading company there should be no taxes on the shares entering the Trust. If the company is not a trading company then as long as the value of the shares is below the nil-rate band (or twice the nil-rate band if both grandparents participate) then no tax should be due on setting up the trust.
When the trust receives a dividend it is taxed at the highest rate (currently 45%). But when the net cash is distributed from the trust to fund the school fees it is treated as the income of the child. The child can then reclaim the tax because of the availability of their personal allowance and lower rate tax bands. The reclaimed tax can then be used to fund further school charges or be repaid to the trust.
Further information
Please contact your usual Menzies tax team representative or e-mail taxconnect@menzies.co.uk
Read the full tax update here.
Posted in Technical updates