June 09, 2022

Article

INTRODUCTION

This article considers the potential benefits of a grandparent settlement in the context of a profitable family company.

The premise of this discussion is that there is a profitable company, whether that be a trading company or an investment company, in which two generations of a family hold shares. The planning is not limited to family groups, and can be applied more widely, but this is a common scenario in our experience and we will use this premise in this article for the sake of clarity.

The second assumption is that the younger generation has minor children (the grandchildren) who are not involved in the company. The purpose of the arrangements is to provide funds for the education and benefit of the grandchildren, typically, but not limited to, the payment of school fees.

THE PROBLEM

The cost of private education can be significant with school fees at many thousands of pounds per term and education spanning kindergarten to university. The education of children is primarily a legal obligation of parents, which can be discharged by sending their children to state schools. The purchase of private education is then a personal choice, to access the type of education provided by those establishments.

There is no tax relief for the cost of private education and parents who choose to educate their children privately must fund these costs out of post-tax income. For a higher rate taxpayer, in simple terms, the parent needs to earn £16,667 for every £10,000 of school fees.

A POSSIBLE SOLUTION

If a child has independent means they are likely to be a basic rate taxpayer. In which case the child needs to have £12,500 income to fund £10,000 of fees. In addition, a child has their own annual personal allowance (currently £12,570) and may receive up to £2,000 of dividends tax free (2022/23 rates). It is therefore much more tax efficient for a child to fund themselves, rather than for a parent to fund their education.

THE TAX POSITION

The obvious source of income for a child in these circumstances is from a shareholding in the family company, but there are some particular challenges in doing this.

Firstly, such a shareholding cannot come from the parents whilst the child is a minor, as tax legislation would deem the income to be taxable on the parent, and not the child. However, there is no such restriction for grandparents, or others, who could give the children shares in the company.

The grandchildren’s shares would normally be in a separate class, e.g. ‘B Shares’, so that appropriate levels of dividends can be paid to the children to fund the school fees. Note below the limitations in respect of dividends described later in this article.

THE USE OF TRUSTS

In the real world there are two issues with this simple structure. Firstly, the school will not normally be willing to contract with a child for private education. Secondly, parents and grandparents are not usually happy to transfer large amounts of capital to children at a young age.

In order to resolve these issues, it would be normal for the grandparents to settle the shares in the family company on trust for the grandchildren, rather than making a direct gift. The school will normally be happy to contract with the trustees and the shares are protected from unwise actions of the grandchildren.

TAXATION OF TRUSTS

As we can see the trust is not used for tax planning as such but consideration needs to be given to how the trust will be taxed. Trusts are separate entities for tax purposes and have their own special tax regime. Consideration needs to be given to the different stages of a trusts life.

Setting up the trust

The normal first step is for the grandparents, in the scenario we are discussing, to transfer a number of shares of the family company into the trust. As previously mentioned, these are normally organised into a separate class and that reorganisation should be tax neutral.

The gift of these shares is both a disposal for capital gains tax purposes and a transfer of value for inheritance tax purposes. If the company is a trading company, then holdover relief for capital gains tax and business property relief for inheritance tax should be available. If it is an investment company, there may be restrictions on these reliefs and care will be needed in this area. A detailed discussion on the rules related to these reliefs is beyond the scope of this article, however, suffice to say that these taxes are not normally a problem.

Running the trust

The trust holds the shares in the company and therefore receives the dividends paid by the company. The trust is subject to income tax on these dividends and the effective rate of tax will be 45%. However, this tax credit is passed to the grandchildren as the income is distributed and the grandchildren can claim a tax refund as appropriate. This is best illustrated with an example.

Suppose school fees are £5,000. In order to fund this the trust will need a dividend from the company of £9,090 on which it will pay £4,090 (45%) leaving £5,000 after tax. The grandchild will have gross income of £9,090, including a tax credit of £4,090. This is within the grandchild’s personal allowance and the tax credit can be recovered in full.

This example is simplified for the sake of clarity and the actual figures in any case will need to be assessed accurately, but the principle is sound.

The trust will also have to consider the ten year anniversary charge for inheritance tax. Provided the company is a trading company this will normally be covered by business property relief. Otherwise, the trust will be subject to inheritance tax at 6% of the value of the assets held at the ten year anniversary, after deducting the available nil rate band. It is usually possible to arrange matters so that no tax is payable, but sometimes significant growth in an investment company can take the trust beyond these limits.

Closing the trust

Ultimately the trust will normally be wound up when all the grandchildren have become adults, although there is some scope to extend this to a further generation if desired. The maximum life of a trust is 120 years.

When the trust is closed, the shares are transferred to the personal ownership of the grandchildren. This is again a disposal for capital gains tax, but any gain can be held over. It is also a transfer of value for inheritance tax and there could be a tax charge if the company is not a trading company and the value of the shares exceeds the available nil rate band. The calculation of the charge is complex but will be less than 6% of the value of the assets in excess of the available nil rate band.

OTHER CONSIDERATIONS

There are some final matters to point out.

Firstly, it is essential that the family company has sufficient profits to fund the school fees. Care is required to ensure that the dividends paid to the trust is a reasonable proportion of the company profits. Whilst the other shareholders do not need to take dividends if they do not wish to, there need to be sufficient profits to allow them to do so if they wish. This prevents HMRC making the argument that the dividends paid to the trust has been provided by the parents forgoing a dividend of their own. If HMRC succeed in that argument then the dividend paid to the trust could be taxed on the parents instead, defeating the tax benefit of the arrangement.

Secondly, it should be noted that the grandchildren themselves will accumulate income in the form of the tax refunds. This can be used for their own personal expenses, e.g. for extra circular activities, sports equipment, etc, which are not included within the school fees contract. Otherwise, they are commonly accumulated for use by the grandchild as they become older, such as a deposit on their first home. Whilst these funds will be held on bare trusts whilst the children are young, they will belong to the children absolutely as soon as they are legally competent to hold them personally.

It should be noted that trusts are generally not reversable. The person establishing the trust is putting capital, and income arising from that capital, outside their reach permanently and it is important that they are happy to do so.

Finally, there are of course, administration expenses in maintaining the trust, which will need to be registered with The Trust Registration Service and will have to make annual and ten yearly tax returns. The trust will also need its own bank account and may incur bank charges. Trustees are not normally remunerated but legal and professional services will be required at different stages of the life of the trust. These costs will normally be funded out of income of the trust which will be subject to income tax at the trust rate.

CONCLUSION

In the appropriate circumstances a settlement as described above can provide a tax efficient structure by which a young person can be supported in their education and beyond. Whilst this article refers to a grandparent settlement in conjunction with a family company, similar benefits can be derived with the use of other assets and in other family or personal relationships.

This article has been written as general guidance only and has been simplified in some respects. Professional advice should always be sought before establishing any similar arrangements to ensure the desired outcome is achieved.

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