Provision for your children
22/11/2010
By Jeremy Passmore, Partner and Head of Private Client.
Some tax and trust issues
When thinking about making gifts to children, much will depend on the ages of the parents and the children:
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gifts on death will have suffered IHT as part of the parents' estates in most cases, but the focus is then on tax-efficient structures for the children, and again this will depend on whether they are still young or by then in middle age.
The early years
Many people will take the view that the children's needs can be funded by the parents out of income or capital on an ongoing basis, and there is an IHT advantage in giving to children in this way. If money is taken out of the parents' estates, and should the parents then die at an unexpectedly young age, IHT will have been saved. This can be achieved by using the following exemptions:
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the annual exemption of £3,000, together with £3,000 for a previous tax year if not used
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the exemption for normal expenditure out of income, where regular gifts are made out of income in excess of what is required to maintain the donor's normal standard of living year on year and
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the exemption for family maintenance, a much neglected provision in Section 11 of the Inheritance Tax Act 1984, where parents set aside money which is intended to cover all of a child's financial needs for maintenance and education up to the age of 18 or when further education finishes.
Gifts can be made via a straightforward bare trust or something more flexible such as a discretionary trust.
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With a bare trust, the capital is treated as belonging to the individual child for capital gains tax as well as IHT, which normally involves a lower capital gains tax rate than the parents'. However, this does not apply to income tax while children are under the age of 18, where trust income is assessed on the parents.
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With a discretionary trust a different tax regime applies. There are rates of 50% for income tax and 28% for capital gains tax. These can be mitigated to some extent by investment strategy and/or through giving beneficiaries a right to income, which then brings the income tax rate down to that applicable to the recipients, subject always to assessment at the parents' income tax rate while a child is under the age of 18.
Older parents
For older families, the incentive to avoid IHT on the parents' estates is normally greater. This can be done in three ways:
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using relevant exemptions including those mentioned above, with normal expenditure out of income often being useful for older parents who may have a decent level of income and a surplus which they can afford to forego.
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larger gifts over and above any exemptions will, generally speaking, only be taxable if the donor fails to survive them by seven years. In the absence of health issues, this will normally be a reasonable gamble to take. If the gift, instead of being made outright, is to some form of trust (other than a bare trust) one would normally be limited to giving no more than the nil rate band figure of £325,000. This avoids what would otherwise be an immediate charge to IHT on any surplus above that figure.
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parents might well want to use a trust. For children at younger ages, the concern is usually about financial irresponsibility. As they grow up concern shifts to the possibilities of problems such as bankruptcy and particularly divorce. While it should not be thought that trusts provide complete cover against all the financial implications of a divorce, they can be of use and confer some protection. A trust will be subject to a 50% rate of income tax, or the individual beneficiary's own rate if he or she is given a right to income, which may well be the better option.
Provision by Will
As regards provision by Will, the funds concerned may well have been assessed to IHT as part of the estate. The question then is what is the best structure for children in terms of their own needs and tax concerns going forwards.
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If the children are still young, then the comments above concerning trusts will be broadly relevant, except that there can be no question of income being taxed at a parent's marginal rate. There should be discussion of the relative merits of the different types of trust for children - whether involving entitlement at the age of 18, or between the ages of 18 and 25, or entitlement to capital at any age but with an immediate right to income being conferred on the children. These arrangements have different ongoing IHT treatments, which should be thought about when making a new Will to ensure that your clients have the most appropriate structure.
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With older families, again there may be the need or wish to use a trust to confer some protection against divorce, bankruptcy or whatever other peril might present itself. Another reason for thinking about a trust at this stage, and this is a planning opportunity of great interest which is often overlooked, is the children's own IHT position.
Suppose the children who are due to inherit are in their late 50s or 60s. They themselves should already be thinking about IHT. If they receive from their parents a lump sum of capital which is likely to form part of their taxable estate, there will then be the problem of trying in some way to get it out of their estate and on to their own children without putting their own financial position at risk.
If, instead, the money is bequeathed to an appropriate type of trust the children can have the benefit of the trust fund during their lifetimes but, and here is the potentially very significant tax saving, the capital value will not form part of their taxable estate when they die. Funds in discretionary trusts can pay IHT at a rate of anywhere between 0% and 6% every ten years and when capital is distributed. By contrast, money held in an individual's estate is likely to be taxed at a flat rate of 40%. So if money can be held in an IHT shelter but still be fully available to the children as beneficiaries, they will have the best of both worlds.
We would strongly recommend that elderly parents considering their Wills, or the children of such parents, think carefully about including such provisions. The children, or rather their own children, could well be very grateful in the years to come.