In this week’s Tax Tuesday, we explore the features and benefits of “The Grandparents’ Settlement” which often proves to be an ideal solution when looking at setting up ‘some form of fund’ for grandchildren.
Please note, when reading the foregoing, that the words “settlement” and “trust” generally refer to exactly the same thing and often tend to be used interchangeably in tax planning (although “settlement” has a wider meaning in certain contexts).
Why The Grandparents’ Settlement?
There are a range of uses to which trusts (or settlements) can be put in the management of families’ estates and in their tax planning. The Grandparents’ Settlement is a perfect example of this. It typically provides a facility whereby assets and income can be held and applied for the benefit of the youngest generation, with those assets and income continuing to remain fully under the control of the senior generation, while, at the same time, taking advantage of the youngest generation’s untapped tax reliefs and allowances.
It is worth noting that all non-taxpaying minors are eligible for a full personal allowance (currently £12,500), meaning each new-born child typically has the potential ability to “contribute” as much as £250,000 of tax-free income capacity, in the first twenty years of their life, to their own upbringing.
Let’s explain with this fictional family:
Bert and Amy Lovegood are 75 and 72 respectively. They are well provided for, financially. They have worked hard in their lifetime and built up a successful office refurbishing business, Productive Spaces Ltd (“PSL”), which is now run by their eldest son, Robin, supported by his younger brother, Jamie. Bert and Amy retained 10% of the shares in the company when their accountants helped them to undertake a valuable and tax-efficient succession of the business to their sons, a little over ten years ago now.
The 10% shares in PSL, which they retained, provided Bert and Amy with a “casting vote” in case Robin and Jamie ever disagreed on anything significant in the business. Those shares have generated some annual dividend income which has been nice, but not essential. Capital extracted from the succession plan, on top of prudent saving and investment throughout their lives, has meant that Bert and Amy have more than enough to live off. Their focus now is very much on how they can further assist their offspring’s families, support one or two members of their wider family who need particular help, and contribute to a number of good causes which they are involved with.
Sons Robin and Jamie both have partners and each couple have two children – that’s three grandsons aged from 8 years down to 2 years, and a new baby girl. The two eldest grandsons go to an independent school and, while that is subsidised by the County Council, there are, nevertheless, fees amounting to roughly £6,000 per annum each to be paid. Aside from the school fees, these four grandchildren are just like any others – costly to maintain!
Bert and Amy want to start to create a fund for their grandchildren, but what might they do?
We recommend that they seriously consider a trust arrangement (a Grandparents’ Settlement) as part of their overall planning.
Features and benefits
These are the features to be proposed, and the benefits to be achieved:
- Bert and Amy will set up a trust (to be formally known as the Bert and Amy Settlement 2020, perhaps). They can deposit a small sum, say £10 cash to get the trust started (and the cash goes into a jar).
- The settlement is a legal arrangement, to be evidenced by a settlement “Deed” which records who is/are the Settlor(s), (i.e. those who have created the settlement), who are to be the Trustees (i.e. those who will control and manage the settlement assets and income), the objects of the settlement, the beneficiaries of the settlement, the powers of the trustees and all other provisions associated with the operation of the trust.
- Bert and Amy will be the Settlors, of course, because they will transfer the initial £10 to get the trust going. Indeed, they will settle substantially more assets soon after, to establish the full desired fund for their descendants.
- Bert and Amy will probably appoint themselves as trustees, which is all perfectly fine and normal. They could appoint others (e.g. Robin and Jamie) instead, but they prefer to preside over the management and the application of the fund, and to maintain full control of it, to ensure it is handled exactly how they intend.
- The potential beneficiaries of the trust are to be various: these will include both Robin and Jamie, their wives, the grandchildren, any unborn grandchildren who might still come along and, indeed, all “remoter issue” in the longer term, just in case this settlement might stay alive and prove to be useful for future generations. This will be a wide class of “discretionary” beneficiaries, i.e. individuals who might benefit from the fund if the trustees so decide (but who will not have any legal entitlement to any of the trust capital, in practice).
- Bert and Amy will not include themselves in the class of beneficiaries. They are giving away assets into this trust for others and it is important, for the favourable tax consequences, that they are not able to benefit from those gifted assets (even though they will still control them, as trustees).
- While the wide class of beneficiaries have only a potential to enjoy any of the capital (all at Bert and Amy’s discretion), the trust will be set up so that the grandchildren enjoy actual “entitlement” to the income from the trust fund (but with full power retained by Bert and Amy to vary these entitlements – i.e. full power to bring in any more grandchildren to income entitlement in due course, and to potentially remove grandchildren from income entitlement).
- This will be what is known as a “flexible life interest settlement”, facilitating the tax management referred to below and maintaining Bert and Amy’s ability to have income paid out to any or all beneficiaries as they ultimately decide is appropriate.
- In practice, Bert and Amy plan to use the income from the trust fund to pay some (or all) of the costs of educating and maintaining the grandchildren. The income entitlements will mean that this income (which will all be applied by the trustees for the grandchildren’s benefit), will be treated for taxation as though it was those children’s own income. (It should be noted that Robin and Jamie cannot achieve the same outcome by settling their own trusts for the same children. A parental settlement yielding income for a minor child is taxable on the parent – hence why this is a structure for to be established and settled by others, usually Grandparents, Uncles, Aunts etc.).
- Having set up the trust, Bert and Amy will transfer their shares in PSL to it (i.e. they will gift those shares to “themselves” as Trustees). This transfer will be free from any Capital Gains Tax because any potential gain arising can be “held over”. The transfer will also be free from any IHT, because the shares will qualify for 100% Business Property Relief.
- Giving away the PSL shares in this way means that the trust fund will have some immediately valuable capital and, most importantly, an established and valuable income stream. Bert and Amy don’t need the £25,000 a year dividends they have been receiving on these shares, but this income will go a long way to paying for current school fees and many other costs of the kids. To date, Robin and Jamie have been settling those fees and costs out of dividends taxed at 32.5%. Going forward, the tax on the income used in this way will be zero as all of it will fall within the grandchildren’s own allowances.
In summary, the trust arrangement will have achieved a range of benefits, including the following:
- An initial transfer of capital value into a place for benefiting the rest of the family.
- A retention of full control over that capital value and full discretion over how it is applied in the future.
- A retention of the right to vote on the shares, albeit now as trustees (and therefore retention of Bert and Amy’s “casting vote” in PSL).
- A facility to convert the current and future income of the trust fund from fully taxable income, into tax-free income, utilising the grandchildren’s tax reliefs and allowances – the non-taxpaying status of each grandchild is likely to last for 20 years or more, so the cumulative Income Tax saving involved in this arrangement can be expected to be significant.
How can we help?
The above settlement arrangement is a potentially valuable part of an overall estate plan, where the circumstances are conducive. There are many variations on this theme.
If you would like to explore whether this could work for you and your wider family, please do not hesitate to get in touch with Tax Partner Chris Barrington.