Most parents recognise the value of making a Will while they have minor children. It allows them to choose a suitable guardian and to ensure that their children are financially provided for. However, whilst leaving small gifts to minor children or grandchildren might be acceptable, it is clearly unwise to leave large sums of money until the child has learned how to manage their money. Setting up a Will trust is a more sensible solution – but what kind of trust should be chosen?
One of the main factors people immediately consider is the tax consequences of their trust. Will trusts may be subject to:
- Inheritance tax (IHT)
- Capital gains tax (CGT)
- Income tax
These are all charged at different rates, depending on the type of trust. There may also be stamp duty land tax (SDLT), stamp duty and stamp duty reserve tax (SDRT) and value added tax (VAT) to pay on some of the transactions made within the trust.
While many trusts are ‘Relevant Property Trusts’ and suffer from anniversary and exit inheritance tax charges, certain types of trust that can be made by parents or grandparents enjoy special tax treatment so they are worth considering where there are minor children involved.
In addition to the tax implications of a particular trust, there are various other factors to consider. For example:
- Flexibility – should the trustees be given discretion as to when they distribute and/or to whom they distribute? This type of flexibility can take account of changes in circumstances of the beneficiaries.
- Ownership – should the beneficiary from a legal and tax perspective ‘own’ the property? If they do, it may be exposed to claims from others. Further, when they die, it will form a part of their estate.
We will look at a number of different possibilities for Will trusts and consider the pros and cons of each. We then explain why the flexibility of a discretionary trust will be the best solution for many.
Bare trust (parents or grandparents)
- Can be made by a parent or grandparent (or someone else)
- No anniversary/exit inheritance tax charges are payable
- No Capital gains tax is payable on distribution of assets to the minor
- The assets belong to the minor / their estate (therefore subject to claims against minor’s assets)
- The minor can call for transfer of property to them at 18 (the trustees have no discretion – even if they do not think the minor is mature enough to manage their financial affairs)
A bare trust means that the property in the trust belongs to the minor, but they cannot take it until they reach the age of 18. If the minor died before then, the property would be part of their estate and pass according to the rules of intestacy. The property would also form part of their assets and so could be used if there was a claim made against them.
If the property generates income or gains prior to the minor reaching 18, it will be taxed at the rate payable by the minor (usually a full income tax and capital gains allowance is available).
On reaching 18, the child can call for the property to be transferred into their name. No additional inheritance tax or capital gains charges are payable at this stage. However, this may not be desirable as the child may not be adequately mature to manage the asset.
Bereaved minor’s trust (BMT) (parents only)
- Until Minor is entitled, property does not form part of their estate/cannot be claimed against.
- No anniversary / exit inheritance tax charges.
- Only available to parents (not grandparents)
- Capital gains tax due on disposal of property to the minor – but hold over relief is available (i.e. the child can pay the tax when they later dispose of the asset)
- If the trustees dispose of the asset, capital gains tax is due at Trust CGT rates (but they may be able to make a vulnerable persons trust election)
A bereaved minor trust (BMT) is a trust that meets the conditions of Section 71A of the Inheritance Tax Act 1984.
To qualify as a BMT (and therefore benefit from special inheritance tax treatment), the trust must meet the conditions of Section 71A which are:
- The trust must be created by Will (or by intestacy – i.e. the child inherits because of the rules where there is no Will)
- It must be for the Deceased’s own child – grandparents cannot make a BMT
- On or before reaching the age of 18, the child must become entitled to the trust property, income from that property and any income that has already been earned up until that point.
- Whilst the child is living and is under the age of 18:
- Any capital must be used for their benefit;
- Any income earned from the property that the trustees decide to use, must be used for their benefit (it may be that alternatively, the income is accumulated – allowed to build up).
- The trustees must not have the power to appoint income or capital elsewhere – it must be for the benefit of the child.
The trustees can in fact still comply with the above requirements if they pay a limited amount of money otherwise than for the benefit of the child. Currently this amount is £3,000 or 3% of the maximum value of the settled property during the tax year.
The benefit of this type of trust is that there are no anniversary or exit charges which sometimes can mean a substantial saving. In addition, unlike the bare trust above, the property doesn’t belong to the child until they reach 18. It cannot therefore be used if a claim is made against the child.
Other points to note:
- A BMT does not have to be created immediately on death. Parents may, for example, decide to leave their property to each other for life, and then to the children, contingent on them reaching 18. Should both parents die while the children are under 18, the trust can meet the above requirements and benefit from the tax savings.
- Grandparents cannot make a BMT. However, a parent can leave property on trust to their child contingent on the child reaching 18, with a substitutional gift to a grandchild if the child should predecease the parent. The trust for the child can be a BMT; the trust for the grandchild will not be. (Strangely, if the trust should be created as a result of intestacy i.e. there is no Will and so the rules as to who should inherit apply, the substituted grandchild will inherit with a BMT).
- Where there is more than one child, the trust can include powers to distribute income or capital unequally, whilst the children are under 18.
- Although inheritance tax is not payable on a BMT, it may still be subject to capital gains and income tax charges. Retained income is payable at the higher trust rates
- If the trustees dispose of/acquire assets within the trust, it will be assessed for capital gains tax. There is an annual allowance which is half the current annual allowance for an individual. So, for example, the 2019/20 allowance for an individual is £12,000 – therefore the trustees get a £6,000 allowance. Capital gains is charged on any gain exceeding that allowance, at 28% for residential property or 20% for any other property. Holdover relief is available where the property is transferred to the child on reaching 18 – this means that the child pays CGT on any gain when they later dispose of it, rather than the trustees paying CGT when the asset goes to the child.
18 – 25 trusts (parents only)
- Trust property does not belong to the minor until the trustees give it to them – does not form part of their estate / not available for claims against them (until 25 at the latest)
- No anniversary inheritance tax charges
- No exit charges under 18
- Max 4.2% exit charge if the trust continues to 25.
- Can only be made by a parent
- Capital gains tax payable if the trustees transfer assets to the child but holdover relief available (i.e. the child can pay CGT when they later dispose of the asset)
- If the trustees dispose of assets during the trust lifetime, capital gains tax is due at Trust rates
An 18-25 trust will provide that the child will take the property in the trust (the capital) on or before their 25th birthday. The income generated from the trust property can either be paid to the child from a certain age (e.g. 18) or paid for the benefit of the child at any age below 25. Any income that is not paid out will be accumulated and given to the child when they reach 25 at the very latest.
Payments of income are subject to the higher trust tax rate but the child may be able to reclaim some income tax after the income is distributed.
As noted above, many Will trusts suffer from anniversary and exit charges. However, with an 18-25 trust, if capital is distributed to the child below the age of 18, no inheritance tax charge is made. If the distribution is after the age of 18 but before the age of 25, a small percentage charge is made (and only if the value of the trust fund exceeds the nil rate band). This is a fraction of 6%, depending on when the property is distributed after the child reaches 18 – for example, if they inherit at 21, the rate is just 1.8%. Even if all of the property is distributed to the ‘child’ at 25, the most that can be charged is 4.2%. This means the trustees can distribute to the child when they feel that the child is mature enough to handle the inheritance, without too much pressure from the prospect of a large inheritance tax bill.
Immediate Post Death Interest (IPDI) (parents and grandparents)
- Can be more flexible than other types.
- No anniversary or exit charges.
- Treated as belonging to minor’s estate
- Capital gains tax payable on distribution to child – no hold over relief available
- Capital gains tax payable on sale of assets by trustees, at Trust CGT rates
Parents or grandparents can give a child or grandchild an immediate post death interest in property. For this to apply, the child must have the right to income from the property, regardless of their age – and this income will be taxed as if it were the child’s. The IPDI can be quite flexible, perhaps suggesting an age where the property should be given to the child but allowing the trustees flexibility to do what they see fit, taking the child’s maturity into account.
There are no anniversary or exit charges with this type of trust. However, the transfer of assets out of this type of trust is a disposal for Capital Gains tax purposes and holdover relief is not usually available.
What is the difference between this and a bare trust? With this type of trust, there is discretion as to when the property is transferred to the child. With a bare trust, the child can call for their inheritance at 18, regardless of whether the trustees think they are capable of managing it.
Trusts for a person with a disability
Trusts for vulnerable people have special tax treatment. These include trusts where one parent has died (which we have covered already), or trusts where the person is entitled to a benefit including:
- Attendance Allowance (the care component at the middle or highest rate; or the mobility component at the highest rate)
- Personal Independence Allowance
- an increased disablement pension
- Constant Attendance Allowance
- Armed Forces Independence Payment
They do not have to claim the benefit – they just have to be entitled to it, to be classed as a vulnerable beneficiary. In addition, someone who cannot manage their own financial affairs due to a mental health condition covered by the Mental Health Act 1983 may fall into this group. (Source: Gov.uk)
If you intend to create a trust for a person with a disability, you should consider the effect this might have on their benefits.
Discretionary trusts (parents and grandparents)
- Maximum flexibility – complete discretion as to whether or not to distribute and how much
- Can be used to allow your trustees the ability to set up further trusts as they see appropriate (which may benefit from the above tax advantages)
- Anniversary and exit charges if trust is allowed to continue.
Discretionary trusts offer the maximum amount of flexibility. Such trusts can last as long as the trustees see fit and there is no obligation for them to distribute either income or capital. If there are several children, the trustees can distribute in uneven shares, or not at all.
The huge benefit of this type of trust is that it can respond to the child’s needs throughout life and respond to changes in circumstances. The trustees can allow the trust to continue up to 125 years, distributing to whichever of the children or grandchild have needs at the time.
Another benefit is that they allow assets to be passed down through the family line, without the 40% IHT charge on each death.
The disadvantage is the tax treatment – this type of trust is subject to ten year anniversary charges (following death) and exit charges:
- No exit charge is payable for property distributed in the first 3 months from death, as no complete quarters have elapsed.
- For any property distributed between 3 months and 2 years, s144 of the Inheritance Tax Act 1984 applies – there is no exit charge and the distribution is ‘read back’ into the Will as if the Deceased had made the gift. This means any of the Deceased’s unused allowances (and any that can be claimed from a previously deceased spouse or civil partner) are available.
- After 2 years, usual exit charges apply.
The anniversary charge is based on the net value of any relevant property in the trust on the day before the anniversary (after deducting debts and any reliefs). The exit charge when property is distributed, to reflect the time that the property stayed in the trust between one ten year anniversary charge and the next.
Capital gains tax on any assets distributed to beneficiaries can be held over (i.e. the beneficiary can pay tax on the gain when they later sell the asset).
Trusts made by your trustees
If you create a discretionary trust in your Will and give your trustees the power to appoint capital onto different trusts, this means they can create any of the above trusts after your death. If done within two years, the inheritance and capital gains tax payable on any new trust they create will be exactly the same as if you created the trust yourself in your Will.
The benefit of this is that your trustees can make a decision at the time of your death (or in the two years following) as to which trust is most suitable. For example, if one of your minor children is in debt or got married at an early age, they may decide that a trust where the property is at risk from claims is unsuitable. For this reason, the discretionary trust will be a good choice for many people.
When you have minor children, a Will is absolutely essential. It ensures appropriate guardians are appointed and allows you to make proper financial provision for their future. It is essential to review your Will and the value of your assets regularly – at least every 3 years and after any significant change of circumstances (see: ‘Do I need to change my Will’) April King Legal offer a free 1 hour appointment with one of our lawyers, and we also offer home visits. Get in touch to book at a time and location convenient to you.
Disclaimer: This article is intended to be a general overview of the trusts that can be made for minors. It is not a substitute for professional advice in relation to your individual circumstances.