Setting up a trust to fund a child's education

Discretionary trust

It is more flexible as it gives trustees discretion to pay income or capital to the beneficiaries.

Unlike a bare trust, there is a class of beneficiaries who can benefit from the trust and these beneficiaries are not entitled to the assets of the trust upon attaining 18 years.

The anti-avoidance provisions which apply to parents setting up a bare trust also apply to discretionary trusts.

The only difference is that the income will become taxable on the parents on distributions to the minor child instead of being taxable on the income as it arises.

If the parents set up the trust with the intention to fund school fees, then a discretionary trust may not be a tax efficient option.

However, as the income is not taxed on the parents or the beneficiaries as it arises, the parents could transfer income producing assets into the trust and the income can be accumulated over a period of time and subsequently used to fund university fees. 

Anti-avoidance provisions exist to avoid parents diverting income to minor children by creating a trust.

Trust tax position

Income received by the discretionary trust is taxed at the additional rate of tax (38.1 per cent for dividends and 45 per cent for other income) subject to the £1,000 standard rate band.

When an income distribution is made to a beneficiary, the beneficiary is deemed to receive the income net of tax at 45 per cent.

This will be received by the beneficiary as non-savings income and must be reported on their personal return for the relevant tax year.

Where the child/grandchild in receipt of the income is not an additional rate tax payer they can claim some or all of this 45 per cent tax credit back.

Given that the discretionary trusts taxes dividends at 38.1 per cent, the trustees could be in a position where they are liable to additional tax if they over-distribute income and the trust has not paid enough tax. 

This is illustrated by the example below.

Beneficiary tax position

If the beneficiary has no other income, they can claim a refund of £10,412 in respect of the tax paid receiving a total amount of £26,193 towards their education costs.

To prevent the additional income tax liability arising on the trustees and ultimately depleting the trust funds, the trustees could distribute an amount which is sufficient to utilise the tax paid by the trust or create an interest in possession (IIP) trust.

IIP trust

Unlike a discretionary trust, the trustees have no power to accumulate income under an IIP trust. The beneficiaries known as the life tenants have a legal right to the net income of the trust and this cannot be retained by the trust.