Mark McLaughlin looks at the use of discretionary trusts to pay school or college fees.
Private school education is expensive. The average cost for day-only private schools is £14,940 per school year; the average boarding school cost in the UK is £35,289 per school year (source: thinkstudent.co.uk).
Trust me!
The natural tendency of their parents and grandparents is to fund the student’s education, if possible. A popular method is to create a trust.
For example, the parents of 18-year-old daughter Ellie set up a discretionary trust to help finance her university education, plus school fees for their two younger children Jamie (age 11) and Susan (age 13). The parents transfer cash from savings of £250,000. The trustees invest the funds until needed. The parents are both higher rate taxpayers.
A gift to a discretionary trust is an immediately chargeable transfer for inheritance tax (IHT) purposes. However, the value of their gifts (£125,000 per parent) is covered by their available nil rate band (£325,000 each for 2022/23), so no IHT liability arises. Furthermore, no capital gains tax liability arises on their cash gifts.
Whose income?
For income tax purposes, anti-avoidance rules on ‘settlements’ need to be considered. The settlements rules can apply if (say) income arises from property in which an individual (the ‘settlor’) retains an interest. A retained interest can arise if there are any circumstances where the gifted asset or any ‘related property’ (e.g., investment income) will, or may, become payable or applicable to the settlor.
Even if the settlor (i.e., each parent in the above example) is specifically excluded from benefiting from the trust, the parent is still ‘caught’ by the settlements rules if trust income is paid to a relevant child of the settlor. A ‘relevant child’ is a minor (i.e., under age 18) who is not married (or a civil partner). So, any trust income distributed to Ellie will not be taxed on her parents.
The effect is that if trust income exceeding £100 is paid to a ‘relevant child’ in a tax year, the trust income is generally treated as the parent’s income. However, this £100 limit applies to the income per parent (i.e., £200 in total). Thus, if trust income is paid towards Jamie’s or Susan’s school fees of more than these amounts, the payments will be taxable on their parents.
Accumulating income
This anti-avoidance rule applies if trust income is paid to (or for the benefit of, or is otherwise treated as income of) the relevant child. However, the charge on the settlor can be prevented if the trustees accumulate the income within the trust until the child reaches age 18. HMRC’s guidance (in the Trusts, Settlements and Estates manual, at TSEM4300) states:
‘Payments out of…accumulated or retained income… (to the extent that there is sufficient retained or accumulated income to match them) made to or for the benefit of a minor child of the settlor (who is neither married nor in a civil partnership) are treated as the parents’ for income tax purposes.’
Practical tip
To the extent future cash gifts to the above discretionary trust were likely to exceed the parents’ available IHT nil rate bands (such that lifetime gifts were liable to IHT at 20%), consideration could be given to the parents establishing a pattern of giving away surplus income to the trust, with a view to securing the ‘normal expenditure out of income’ IHT exemption.
