When parents are taxed on trust income

by Malcolm Finney of www.taxinsider.co.uk

Trusts have been used for many years as tax planning vehicles. The idea of using a trust is generally to attempt to avoid (i.e. save) tax or as a vehicle to protect family assets from profligate offspring (whether tax effective or not).

Unfortunately (for the taxpayer) the widespread use of trusts for tax avoidance purposes has led to the introduction of legislation designed to counteract any tax advantages that may accrue. Such legislation has been introduced over many years in a piecemeal fashion, which has resulted in a complex web difficult to unravel for the tax adviser - and impossible for the man on the Clapham omnibus!

Case study

Let's consider a typical family, the Snodgrass’s, who are mulling over a bit of tax planning. The family comprises Mr. and Mrs. Snodgrass and their two children, Tom and Tracy, aged 14 and 12 respectively.

Example 1

Mr. Snodgrass is a 40 per cent taxpayer and Mrs. Snodgrass a 20 per cent taxpayer. Mr. Snodgrass feels that he has read enough about the use of trusts to enable him and his family to reduce their income tax liabilities.

Mr. Snodgrass decides that they should set up a bare trust for each of the two children. Mrs. Snodgrass agrees to transfer cash of £5,000 split into two lots of £2,500 into two bare trusts; one for Tom and one for Tracy. Each £2,500 produces £125 annual bank interest.

Although the income (i.e. bank interest) belongs to Tom and Tracy, for income tax purposes it's treated as that of Mrs. Snodgrass who is thus liable to income tax on it at her marginal rate of income tax; no income tax is avoided or reduced (if the income was £100 or less per annum then Mrs. Snodgrass would not be subject to tax on it, i.e. some tax would be saved).

Example 2

The Snodgrass’s also own two “buy to let” properties, each property producing annual rental income of £7,200. They decide that it might be a good idea to transfer one of the properties into a discretionary trust for Tom and Tracy. The income generated and any capital growth could be used to help Tom and Tracy through university; to help buy a flat/house; or as pocket money from time to time.

The income of the trust is subject to income tax on the part of the trustees at 50 per cent (a rate higher than either Mr. or Mrs. Snodgrass pay). If the trustees pay out any of the income to either Tom or Tracy whilst they are under age 18, then Mr. and Mrs. Snodgrass are liable to income tax on the income so paid out; whether the income is paid out or not, no income tax is avoided or reduced.

Example 3

Mrs. Snodgrass’s’ mother (a 50 per cent taxpayer) has decided that she would like to provide a little something for Tom and Tracy when they become 18 and prior to that provide them with a little pocket money. On the advice of Mr. Snodgrass she sets up a trust (putting £10,000 cash into it) under which Tom and Tracy get the capital (50 per cent each) on attaining age 18 and, in the meantime, share any income 50/50.

In this case the use of a trust is tax effective. As Tom and Tracy are each entitled to the income of the trust as it arises, they (i.e. Tom and Tracy; not the trustees or Mrs. Snodgrass’ mother) are each liable to income tax on the income against which they can offset their personal allowance; income tax is reduced as the income is no longer subject to Mrs. Snodgrass’ mother’s tax rate of 50 per cent.

Example 4

In an attempt to reduce their inheritance tax (IHT) exposure, shares owned by Mr. Snodgrass (worth £50,000) are transferred into a discretionary trust with the beneficiaries comprising the whole family (Mr. and Mrs. Snodgrass want to remain as beneficiaries as they feel that they might need to benefit from any dividend income or proceeds from any share sales at some time in the future).

The trust income is treated for income tax purposes as that of Mr. Snodgrass and no income tax is avoided or reduced (and in fact no IHT is avoided either, as the transfer on trust is treated as a ‘gift with reservation’ and the shares remain in Mr. Snodgrass' estate on his death).

Example 5

Some years ago Mr. and Mrs. Snodgrass purchased a Spanish holiday home for £40,000; it's now worth circa £75,000. They have read that UK taxes may be saved if this is transferred into an offshore company or trust.

Whether the transfer is to an offshore (e.g. Isle of Man) company or trust any rental income of the company/trust is simply subject to income tax on the part of Mr. and Mrs. Snodgrass; no income tax is avoided or reduced. 

In addition, the transfer of the property to the company/trust will precipitate a UK capital gains tax (CGT) charge on their part (even though they will not receive any cash, but shares, on the transfer) and CGT is also payable by Mr. and Mrs. Snodgrass on a future sale by the company/trust.

Trusts set up by parents (but not grandparents) are not in general particularly effective to avoid income tax although, in practice, trusts may be used to mitigate CGT and/or IHT.

Practical tip:

The tax treatment of trusts is very complex. This is an area, perhaps more than any other, where professional advice will pay dividends; “do it yourself” trusts will probably only end up in tears.

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Published on: September 1, 2012

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