There are many reasons to set up a trust fund for a child, whether your own or a grandchild. Trust funds for children can offer financial security during key developmental stages of their life, tax efficiency for passing assets on, asset protection, and control over distribution.
Because of tax changes over the last 20 years or so, nowadays trusts are largely used as a means of controlling who receives what and when.
This article defines some key trust terms, provides an overview of types, We'll examine legal requirements and tax implications.
What is a trust fund?
A trust fund holds assets for a beneficiary's benefit. The person who derives benefit from the assets is not the legal owner. That has advantages.
Trust fund terminology
The legal term for a trust fund is a 'settlement'. The person who creates the fund is known as the 'settlor'. The people who manage the assets in it are the 'trustees' and the people who benefit from it are the 'beneficiaries'.
And trusts? Technically, they are the rules under which a settlement operates. But going forward in this article we'll abbreviate 'trust fund' to 'trust' meaning a 'settlement'.
What are the benefits of setting up a trust fund for a child?
A trust fund is usually set up for a child for one or both of two reasons. The first is to pass wealth down generations such that it bypasses people who might otherwise own it. The second is to control what happens to that wealth - who receives it, when, for what reasons and how.
Trusts can guarantee funds are available for specific purposes like education or a house deposit that can help secure a child's financial future. They can provide money for care. They can shield assets from creditors (whether the creditors of the settlor, or the creditors of the beneficiaries). And you can have some say over how and when the child uses the money.
What are the main types of trust funds for children?
There are many different types of trusts that could be used where the beneficiaries are children.
Bare trusts and discretionary trusts are the two primary types of trusts for children.
Accumulation trusts, which allow trustees to accumulate income within the trust, are another option to consider.
Mixed trusts, combining elements of different trust types, offer additional flexibility in some situations.
Bare trusts
Bare trusts keep the assets in the trustee's name until the child beneficiary is 18. On reaching that age, the beneficiary has the right to all the income and capital. Trust income generated within a bare trust belongs to the beneficiary for tax purposes.
Bare trusts are suitable for small gifts or when you're comfortable with the child having full access at 18.
Discretionary trusts
The key feature of discretionary trust funds is that the trustees have discretion (i.e. can choose) which beneficiaries receive capital and income, and when and how to distribute funds. Trustees have full control over distributions.
An implication of this is that beneficiaries have no automatic right to trust assets, protecting against irresponsible spending and allowing trustees to be flexible with distributions according to beneficiaries needs at different times.
Unlike bare trusts, there is no set age at which beneficiaries automatically gain access to the trust's assets.
If you set up a discretionary trust for your children's education, you could specify that the trustees may only allocate funds for educational expenses.
Legal requirements for establishing a trust fund in the UK
UK trust law requires three elements for a valid trust: intention to create a trust, certainty of subject matter (assets), and certainty of objects (beneficiaries), as well as the ability to transfer assets into the trust. The Trustee Act 2000 governs trustee duties and powers. Trusts involving land or property must be made in writing.
For other assets, verbal trusts are possible but not recommended.
Written trust deeds provide clarity and legal certainty, ensuring your trust fund is legally binding and protects all the assets for your children's benefit. The legal framework has been designed to safeguard the interests of all parties involved in the trust.
How do you set up a trust fund for a child?
You set up a trust fund by choosing the trust type, identifying assets, appointing trustees, drafting the trust deed, transferring assets, and registering with HMRC if required.
Each step necessitates careful consideration to ensure the trust meets your objectives and complies with legal requirements.
How do you choose assets for the trust?
You select assets for the trust based on liquidity, growth potential, tax implications, and suitability for the trust's purpose.
Cash provides immediate liquidity, while stocks and shares offer growth potential. Property can generate steady income, and life insurance policies protect beneficiaries. You might also consider including a savings account as part of the trust's assets for additional security.
For a trust funding university education in 10 years, you might choose a combination of cash for short-term stability and stocks for long-term growth potential, diversifying across different investment types to create a balanced portfolio of investments.
What should you consider when appointing trustees?
When selecting trustees for child trust funds evaluate trustworthiness, financial competence, willingness to serve, understanding of your wishes, and potential conflicts of interest. Family members are often first choices.
A trust must have at least two trustees and no more than four to manage the trust's assets and make decisions on behalf of and in the beneficiaries' best interests. We explain trustees' roles and powers in another article.
The appointment process involves obtaining trustees' consent and documenting their appointment in the trust deed. You can appoint yourself as a trustee and include provisions for changing trustees if necessary.
What are the tax implications of trust funds for children?
Trust funds for children come with income tax, capital gains tax, and inheritance tax considerations. Tax regulations vary based on trust type and management.
In bare trusts, income is taxed as the child's, while discretionary trusts typically tax income at the trust rate, which is often higher. Capital gains tax applies to profits from asset sales within the trust. Inheritance tax may affect assets transferred into or out of the trust.
Inheritance tax
Inheritance tax rules differ for various trust types. For example, discretionary trusts have specific IHT considerations. Charges may apply on establishment (if above the nil-rate band), during the trust's existence (ten-yearly charges), and on distribution, which the trust may need to pay.
Trusts exceeding the nil-rate band may incur immediate tax.
How can you maintain control and flexibility in trust fund management?
You can retain oversight over trust assets while allowing flexibility through three key strategies: letters of wishes, protectors, and amendment provisions.
Letters of wishes are non-binding documents stating your intentions for the trust. Protectors are persons with authority to oversee trustees. Amendment provisions in the trust deed permit future modifications.
If you establish a trust for your children's education, you might include a letter of wishes outlining your preferences for fund use. This provides trustees discretion to adapt to changing circumstances. You could appoint a trusted family friend as protector to ensure trustees adhere to your intentions.
When should you seek professional advice for trust fund creation?
You need professional advice for trust fund creation in complicated family circumstances, substantial estates, cross-border considerations, or questions regarding tax efficiency. Seek advice from solicitors focusing on trusts and estates, and chartered accountants or chartered tax advisers for tax-specific advice.