Mark Green discusses the role of parental settlement rules in tax planning
Parents' using their children to pass down wealth to future generations is commonplace in inheritance tax planning. Parents will often set up trusts for this purpose, but if the trust produces income for their minor child then anti-avoidance rules known as the ‘parental settlement rules' will apply.
These rules are contained in Section 629 Income Tax (Trading and Other Income) Act 2005. A minor child for the purposes of these rules is a child of the settlor who is under age 18 and is not married or in a registered civil partnership.
Different types of trust
Parental settlements for minor children will usually take the form of one of the following types of trusts:
- Bare or absolute trusts: where the child is absolutely entitled to the income and the capital of the trust
- Interest in possession trusts: where the child, as the life tenant beneficiary, will be entitled to all the income
- Discretionary/accumulation trusts: where the trustees can retain and add income to the capital of the trust or make payments to, or for the benefit of, the child at their discretion
If a parent creates one of these trusts, the income, which arises, is treated for income tax purposes as the income of the settlor parent if it is paid to, or for the benefit of, or would otherwise be treated as income of an unmarried minor child of the settlor.
The ‘parental settlement rules' only apply to trusts where a minor child can benefit from the trust and the settlor parent is excluded. The rules do not therefore apply once the child turns age 18. Different anti-avoidance rules in the form of the ‘settlor-interested trusts rules' will apply if the parents can benefit from the trust.
If the income arising from all parental settlements made by a parent to a child is less than £100, the child's trust income is not counted as the settlor parent's for income tax purposes. Once the £100 limit is exceeded, however, the total income will be taxed as the settlor parent's for income tax purposes.
In the following scenarios each type of trust is set up with cash, the parents are the settlors/trustees and the trust income exceeds £100 gross.
Parents create a trust for their minor child and the trustees open a building society account for the trust, which generates income in the form of interest. However, for this example lets assume no payments have been made to the minor child and the trust retains all the income.
Although no income is paid to or for the benefit of the child, section 629 still applies to treat the income as that of the parent because the income under the trust belongs to the child even though it was not paid out to them. Section 629 applies whether or not income is paid to the minor child.
Interest in Possession Trusts
Parents create a trust for their two children and invest the cash in shares to generate an income in the form of dividends. The two children are the life tenant beneficiaries, which means they each have an equal right to the income from the trust.
One child is an adult (over age 18) and the other is a minor. Section 629 applies to treat the minor child's share of the income as that of the parents because the income belongs to the minor child. However, section 629 does not apply to the income of the adult child; this means an adult child may set off their personal allowance against this income or pay tax at their marginal rate.
Parents create a trust for their minor child and invest the cash in shares to generate an income in the form of dividends from which they as trustees make a discretionary payment to the child. Section 629 applies and treats this payment as the income of the parent.
Payments out of current or accumulated income made to or for the benefit of a minor child are treated as the income of the parent's for income tax purposes. However, any income that is accumulated in the discretionary trust will, instead, be subject to the trust rate of income tax (45% for non-dividend income and 37.5% for dividend income).
Although the ‘parental settlement rules' apply to trusts set up by parents for the benefit of their minor children, they do not apply to trusts set up by grandparents - or indeed anyone else - in which case any income paid to the child will be taxed as income of that child. This can be particularly advantageous for grandparents wishing to assist with the educational costs for their grandchildren as well as undertaking inheritance tax planning.
Mark Green is head of tax and estate planning at Legal & General
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