Parents or grandparents may wish to set money aside for their children/grandchildren by way of lifetime gift. For small sums, the money can be given to the child’s parent or guardian to invest on the child’s behalf. However, for larger sums a trust may be more appropriate, for reasons including:
- Control– the parent/grandparent can retain a degree of control over the trust fund by being a trustee
- Flexibility– nobody knows what the future may hold and a flexible trust allows the trustees to take account of beneficiaries’ changing circumstances and needs
- Asset protection– most people feel that 18 is too young an age to receive a large capital sum
If flexibility is the most important factor, a discretionary trust may be appropriate. Under a discretionary trust, the trustees have complete discretion as to which beneficiary(ies) receive capital or income and as to when they receive it. Beneficiaries may receive unequal amounts and no beneficiary has a right to either income or capital in the absence of a decision by the trustees in their favour.
As an alternative, where control and asset protection are the main concerns, children may be given fixed shares of the trust fund, but their entitlement to capital made contingent on their reaching a specified age greater than 18 (e.g. 21 or 25). Further flexibility can be built in to such trusts by giving the trustees an overriding power to alter the share each child will receive. Trustees have wide powers to use income from a child’s share of the trust fund for his maintenance, education and benefit, while he is under the specified age (for example, to pay school fees).
For smaller trust funds, where the costs of administering a trust may be disproportionate to the benefits, a bare trust may be appropriate. A bare trust is one where the beneficiary has an immediate right to both the capital and income in the trust but the trust fund is held on his behalf by others (trustees). This is a common way of holding funds on behalf of a minor child. However, when the child reaches the age of 18 he can demand that the trust fund be transferred to him (as once 18 he can give a good receipt for the money).
Taxation of Trusts for Children
Bare trusts:
- The beneficiary is taxed on the income at his own marginal rate (a child may well be a non-taxpayer) but see NOTE below
- Gains arising are treated as the gains of the beneficiary and he can use his own annual allowance
- For inheritance tax (IHT), the beneficiary is treated as owning the assets. Therefore if he should die, the bare trust assets form part of his estate. There is no charge to IHT when the beneficiary attains 18 and the assets are transferred to him.
Discretionary trusts and trusts subject to an age contingency:
- The trustees are taxed on income arising to the trust at 45% (a tax reclaim may be made if income is distributed to a beneficiary whose marginal tax rate is lower than this) but see NOTE below
- The trustees must pay capital gains tax on gains in excess of the trust’s annual allowance at the rate of 28%. The trust annual allowance is half the individual annual allowance.
- Depending on the value of the trust fund, there is potentially a charge to inheritance tax (1) when capital payments are made out of the trust (for example, on a distribution of capital to a beneficiary) and (2)on every tenth anniversary of the start of the trust. However, IHT is generally payable only if the assets of the trust exceed the ‘nil rate band’ (currently £325,000) and then only at 6% on the excess value over the nil rate band (taking account of assets paid out during the previous 10 years).
NOTE: Where a parent sets up a trust for their minor child, income (provided it exceeds £100) is treated as the income of the parent, rather than that of the child and so is taxed at the parent’s marginal rate.
This is not intended to be an exhaustive guide to what is a complex area of law and readers should seek professional advice for their own particular circumstances.
“Trusts for Children – Some Options” was originally published on 20th July 2015 and last revised on 16th December 2021. See also our legal guide Gifts & Loans to Children.