Trusts : Setting up a trust fund for your children's education

Overview
What is a trust?
Why should I care?
Types of UK trust
Bare Trust
Discretionary Accounts
Contigent Trusts
Discounted Gift Trust
Interest in possession trust
Accumulation and maintenance trust
Mixed trust
Setting up a trust - Seek Professional Advice
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Overview

• Parents, guardians, grandparents and friends can set up a trust on behalf of a child
• Inside this trust, "capital" can be held including land or property, shares, money, antiques or other valuable property
• When your children reach 18, the trust can be re-registered in the their names
• For tax purposes, the "capital" inside the trust belongs to the child, not the adults

What is a trust?

A trust is simply a means of holding and managing a "property" or "capital" for people who may not be ready to manage it for themselves (i.e. your children under the age of 18).

Why should I care?

Trusts are particularly useful if your children have missed out on the Child Trust Fund vouchers because it works like a children's investment plan, with the money held in what is known as a "bare trust" (see below).  It will only attract tax if your child exceeds his or her annual personal tax allowance which is unlikely.  It is also potentially exempt from inheritance tax, and unlike the CTF there is no cap on the amount that can be invested.

Types of UK trusts

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The are several types of trusts you can set up for your children.  Here we include some of the main Trusts available and the basic issues involved with each:

Bare Trust
A bare trust, also known as a 'simple trust', is one in which the trustee (you, the parent/guardian) owns the assets for the benefit of the beneficiary (your child).  The property is held in the name of a trustee, but that trustee has no discretion over what income to pay the beneficiary.  In effect, the trustee is a nominee in whose name the property is held.  The trustee has no active duties to perform.

When the asset is sold the capital gains will be taxed as your child's.  Since everyone is entitled to an annual capital gains allowance of £8,800 (including children), if the gains are under that amount, it will be tax-free.

Example Tung and Yen decide to invest £20,000 for their two-year-old daughter Gracie in a bare trust that buys shares in unit trusts.  The fund grows at a rate of 8% per year for 16 years.   When Gracie reaches 18, she will have an Eggnest of £75,565.  It is highly unlikely that she will have to pay any taxes on her gains.

Disposal Proceeds	£75,565
Minus initial investment	(£18,000)
Gain	£57,565
Minus Taper relief at 40%	(£23,026)
Gain after taper relief	£34,539
Minus annual allowance (5 April)	£13,644
Minus annual allowance (6 April)	£14,053
Taxable gain	£6,843

Assumptions

1.  Providing Gracie takes out her investment once on 5 April (last day of the financial year) and another on the 6th of April (first day of the new financial year)
2.  Annual Capital Gains allowance will increase at 2.5% per annum
3.  Taper relief stays the same at 40%
4.  Annual growth rate of 8% per annum

Advantages of a bare trust

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• your children have the same personal allowance as you.  In the year ending April 2006, the personal income allowance is £5035 and £8,800 for capital gains. See Children and Taxation
• any taxable income from investments can be set against their allowance so all returns are tax free if your children remain non-taxpayers
• you retain control of the money until your children reach 18

Disadvantages of a bare trust

• when money is passed from you to your children, only the first £100 of the interest is tax free.  You must be careful not to go over this limit as the whole of the interest will be taxed upon you, not your children. See Children and Taxation
• you have no legal control over how and when the money is used.  This means that when your children reach 18, there is nothing stopping them from spending it all on a good night out. See Teaching Children Money Habits for Life

Discretionary Accounts

An investment is made in your name, but held for the account of your children.  You remain the legal owner, with your children being the beneficial owners.  With a discretionary trust you decide how much income or capital, if any, to pay to each of the beneficiaries - but neither you or your children have an automatic right to either.   A discretionary trust is a way you can pass on property while you are still alive and still keep some control over it through the terms of the trust deed.

Example Myriam and Roy put money into a discretionary account trust, to be held for 25 years, for the benefit of their five grandchildren.  As trustees, Miriam and Roy can decide how to invest or use the money and any interest it earns to benefit the grandchildren. So, when the children are young, the trustees might decide to pay for piano lessons. As they get older, the trustees might pay towards a wedding. After 25 years, the trustees wind up the trust and distribute all of the money to all the grandchildren.

Interest in possession trust

This type of trust exists when a beneficiary, known in this case as an 'income beneficiary', has a current legal right to the income from the trust as it arises.  The trustee(s) must pass all of the income received, less any of their expenses and tax, to the beneficiary.

A beneficiary who is entitled to the income of the trust for life is known as a 'life tenant' (a 'liferenter' in Scotland) or as having a 'life interest' (a 'liferent interest' in Scotland).

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The income beneficiary need not, and often does not, have any rights over the capital of such a trust.  Normally, the capital will pass to a different beneficiary, or beneficiaries, at a specific time in the future or after a specific future event.  Depending on the terms of the trust, the trustees might have the power to pay capital to a beneficiary even though that beneficiary only has a right to receive income.

A beneficiary who is entitled to the trust capital is known as the 'remaindermen' ('fiar' in Scotland) or the 'capital beneficiary'.

Example Hong is married to Cuc. Upon his death, Hong arranged for a trust in which all the shares he owns are to be held. The dividends earned on these shares are to go to Cuc for the rest of her life, and when she dies the shares pass to the children or grandchildren. Cuc has an 'interest in possession' in the trust as she is entitled to the income (the dividends) arising on it for the rest of her life. However, Cuc has no right to the capital, so when she dies, the trust ceases and all the capital (the shares) pass to her children or grandchildren (the remaindermen or fiars).

Contingent Trusts

A more specialised version of the interest in possession trust.  In this scenario, any beneficiary given a life interest in the income of the trust can automatically lose this entitlement on the occurence of a specified list of situations.  The most common event is the personal bankruptcy of the beneficiary.  This is designed to protect the income of the trust from the beneficiary's creditors. 

Discounted Gift Trust

This is a lump sum investment, written under trust, providing annual income to and control over the beneficiary of the trust fund. Investment growth is outside of the estate from day one, with further savings after 7 years.

A key feature of a discounted gift trust is the immediate inheritance tax savings in the event of death within 7 years.  This is because the initial gift into trust is reduced when it comes to calculating inheritence tax (IHT). The Discounted Gift Trust exists to help individuals who have a potential estate planning problem, but do not want to give away their savings outright. 

It allows individuals to make a gift to a trust for their children or grandchildren (or other beneficiaries) which can reduce their IHT liability whilst still benefiting from regular capital payments from the trust. It is a combination of a Discounted Gift Trust and an Investment Bond.

The plan is highly flexible. Trustees have the freedom to include and exclude beneficiaries in favour of other beneficiaries named in the Plan. For example, future grandchildren are included as potential beneficiaries so the changing shape of their family could be taken into account as time passes.

Accumulation and maintenance trust

An accumulation and maintenance trust is typically opened to provide money for grandchildren when they are young.  Any income that isn't spent is added to the trust property, all of which later passes to the grandchildren.

In England and Wales beneficiaries become entitled to a trust property between ages 18 and 25, the trust turns into an 'income in possession' trust.  In Scotland, the trust usually ends when the beneficiaries reach 16. 

Example Gene puts money into an accumulation and maintenance trust for the benefit of his granddaughter Coco. The trustees, Gene and his wife, can make payments to Coco from the trust for her maintenance and they will accumulate any remaining income. The terms of the trust give Coco the capital and any accumulated income at the age of 25. So on her 25th birthday, Coco is entitled to all the money accrued at that date.

Mixed trust

A mixed trust is a mixture of more than one type of trust:

• interest in possession trust and a discretionary trust, or
• interest in possession trust and an accumulation and maintenance trust.

Example Jimmie and Lisa both have an accumulation and maintenance trust. This trust becomes a mixed trust when Jimmie reaches 18 while Lisa is still 15. The part of the trust benefiting Jimmie becomes an interest in possession trust while the part that benefits Lisa remains an accumulation and maintenance trust until she reaches 18.

Setting up a trust - Seek Professional Advice

Before setting up a trust it's a good idea to get advice from a solicitor, who can also draw up the trust deed and give you advice on related legal matters.  It's also advisable to speak to a Financial Advisor or accountant before agreeing to be a trustee.

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