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Absolute Trust - Using a grandchild's allowances and exemptions

When considering making lifetime gifts, many individuals prefer to set up a discretionary trust as this enables them to retain control and flexibility as they can act alongside the other trustees and can decide when to make payments out to a beneficiary. However, from a tax perspective any income and capital gain will be taxed at the trust rate(s). Income above the standard rate band, usually £1,000 assuming only one trust has been settled by the same settlor, will be subject to income tax at 45% or 39.35% on dividend income. From the 2024/25 tax year the standard rate band will be eliminated, and all income will be subject to the rate applicable to trusts. If income is paid out to a beneficiary, they are treated as receiving it with a 45% tax credit and can therefore reclaim some tax depending on their personal income tax position. In addition, capital gains over and above the annual exemption of £3,000, again assuming only one trust has been settled, are subject to capital gains tax (CGT) at 20% or 28% for residential property. From 2024/25 tax year the CGT annual exemption will reduce to £1,500. If capital is appointed out then this gives rise to an exit charge for inheritance tax (IHT) purposes, however whether any tax is due will depend on the precise facts.

By setting up an absolute trust, both the income and capital is held absolutely for the benefit of the beneficiary. This means that the beneficiary will have access to the trust fund at age 18 (age 16 in Scotland). From a tax perspective, as the income is held absolutely for the beneficiary under the terms of the absolute trust the beneficiary is normally personally subject to income tax on any income arising. The only exception to this rule is where the parental settlement rules apply, i.e. the donor is the parent. Here if gross income, including chargeable event gains on bonds, exceeds £100 in a tax year from all gifts made by the same parent it is assessed on the parent(s) in respect of any beneficiary who is under age 18 and unmarried, or not in a civil partnership. However, where the trust is settled by a grandparent the absolute beneficiary is taxable on any income and could therefore use their personal allowances against any income. For CGT purposes, any capital gain is taxed on the beneficiary and thus they are able to use their annual capital gains tax exemption – currently £6,000 against any gains, reducing to £3,000 for the 2024/25 tax year. This tax treatment means that, where a grandparent is considering making a gift into trust for a grandchild, an absolute trust may be a suitable option. 

 

For IHT purposes the person creating the trust is treated as making a potentially exempt transfer which will normally fall out of account once the settlor/donor has survived seven years from the date of the gift.

 

Example:

 

Nagin decides to set up an absolute trust for the benefit of his grandson, Shay who is twelve. He has £250,000 to invest and wishes to use the money to help pay for his private school fees which amount to £12,400 per annum but he also wishes to provide funds for higher education. His parents only require around £4,000 as a top-up to the payments that they are currently making.

 

Nagin uses his IHT annual exemption each year if favour of his nephew, but he has not made any other gifts in his lifetime.

 

He decides to set up an absolute trust for Shay. Regardless of the amount he decides to settle there is no lifetime IHT to pay on the gift as the trust is an absolute trust.

 

Of the £250,000, £150,000 is invested in an offshore investment bond which is split into 100 segments and £100,000 is invested in a unit trust portfolio of 100,000 units yielding 4% each year. The cost of each unit is £1. The dividend income will be taxed on Shay as he is the absolute beneficiary of the trust.

 

Shay will be entitled to benefit from a personal allowance, the starting rate band for savings income, where relevant, the personal savings allowance and the dividend allowance.

 

In this case, the total amount generated (£4,000) will be covered by his personal allowance so there is no income tax to pay.

 

Six years go by and further funds of £8,500 are needed to help with the fees. At that time each unit is worth £1.50p.

 

The trustees decide to encash 6,000 units from the unit trust portfolio. This provides £9,000 (6,000 x £1.50p) which is more than sufficient.

 

The capital gain would be £3,000 [(£1.50p – £1) x 6,000] which will be covered by Shay’s annual exemption rather than the trust rate (using 2024/25 allowance) so there is no CGT to pay.

 

Another option is for the trustees to make use of the 5% tax deferred allowance and withdraw £8,500 from the investment bond. This will not give rise to an immediate tax charge as it is well within the amount available.

 

Alternatively, the trustees could consider encashing segments. Let’s say the investment bond has grown to £201,000.

 

If the trustees were to surrender five segments this provides funds of £10,050 (£201,000/100 = £2,010 x 5).

 

The chargeable event gain will be based on:

 

[surrender value of each segment – amount invested in each segment]

 

£201,000/100 = £2,010

 

£150,000/100 = £1,500

 

£2,010 - £1,500 = £510

 

£510 x 5 = £2,550

 

The chargeable event gain of £2,550 together with the dividend income of £4,000 is all within Shay’s personal allowance of £12,570 so there will be no income tax to pay.

 

In future years, tax savings can be maximised where the trustees withdraw funds to use Shay’s personal allowance and CGT tax annual exemption.

 

Summary

 

While an absolute trust may not appeal to some, this article provides a brief overview of how such a trust could effectively use a beneficiary’s personal allowances and/or annual exemption for CGT.  This applies even with the reduction in the CGT exemption and can be used as a way to provide additional funds for education or even to help with other costs, such as providing funds towards a deposit for a property. 

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