Since children right from the time of birth have a full income tax personal allowance and annual capital gains tax exemption, it is always worth exploring how these allowances can be used within overall family finances.
As is well known, the income tax rules are fairly harsh in that any gifts from parents to infant children will result in the income from the funds concerned continuing to be taxed on the parents. The parents could put funds within their inheritance tax (IHT) nil bands into a children’s settlement and as long as the income is accumulated it will not be taxed as theirs, but that achieves little because trusts pay the highest rate of income tax in any event.
Possible solutions?
Alternatively, parents could of course give money to the children and ensure that it is invested so as not to produce income, but to produce capital gains, since the capital gains of infants are not taxed on the parents in any circumstances.
Another possibility is to invest the funds in single premium life insurance products which allow 5% withdrawals each year without tax consequences, but the only purpose in doing this would be to remove funds from the parent’s estates for IHT purposes so that after a seven year period the gifts would fall out of account for IHT. Apart from this, the parents could themselves invest in that type of investment product and take the 5% withdrawals tax free, and before final encashment assign the bond tax free to children whilst at university.
Gifts by grandparents
On the other hand, gifts from grandparents to their infant grandchildren are much more tax-efficient. In practice, the gift would be made to the parents as trustees for their children, but the income could not be taxed as the parents’ and all the children’s tax allowances can be used. If the grandparents survive the gift for seven years, their estates will have been reduced for IHT purposes without liability. The capital gains tax position of any non-cash gifts should of course be considered.
In the context of estate planning it is preferable for any will to be drafted taking into account the particular wishes of the legatees under it, rather than leaving the legatees to correct the position by deed of variation after the death. Under a deed of variation, any gift made to a legatee’s own infant children will be caught by the income tax rule mentioned above so that the income will continue to be taxed on the parent/legatee. If the will had been drafted in the first place to make gifts direct to the grandchildren this result would not arise. There are three types of will trusts for infant children under the IHT provisions, these being bereaved minor’s trusts, age 18 – 25 trusts and bare trusts, but in practice only the last two are likely to be of interest.
Practical Tip:
Age 18-25 trusts are generally in favour, but bare trusts might be just as suitable. A gift by will on bare trusts means that the child will be entitled to the funds at age 18 and the income will be taxed as the child’s own.
However, it is possible to include all normal trustee powers in the bare trust document, including investment powers and powers of advancement under Trustee Act 1925, section 32, which can be exercised by the trustees before the child attains age 18. Any advancement must be primarily for the benefit of the child, but could (for example) be into longer term discretionary trusts of which he or she is the primary beneficiary. Furthermore, there is no provision under the IHT legislation dealing specifically with bare trusts, so it is not clear that any transfer of value arises where such an advancement is made.
