Inheritance tax, cash gifts and the use of trusts

Question.

I read with interest your recent column which explained some ‘traps for the unwary’ when a parent helps a child on to the property ladder. If a parent decides instead to make a one-off gift of cash to an adult child or student what are the tax implications for the parent and for the child?

Answer.

There are many possible tax planning opportunities to ensure that gifts of cash to the next generation do not trigger adverse tax charges.

A gift of cash by an individual does not fall within the scope of capital gains tax (CGT) as cash is regarded as an ‘exempt asset’. From an income tax perspective any interest arising on gifted cash is likely to benefit from the child’s basic rate status meaning that a lower tax rate may apply, in comparison to the parent who may have significant other sources of income which might push the interest into the parent’s higher rate or additional rate tax band. Every individual also benefits from a tax-free personal savings allowance of £1,000, so interest generated on the cash, once it is in the adult child’s name, is likely to be tax free. This assumes the child is a student or not yet working.

The inheritance tax (IHT) implications of making a gift of cash are not so straightforward however. A gift of cash is regarded as a ‘Potentially Exempt Transfer’ (PET) and can become chargeable to tax if the parent dies within seven years of making the gift. However, if the parent lives for at least seven years, subsequent to making the gift, the cash gifted would fall outside the parent’s estate for IHT. This would therefore result in a significant tax saving as IHT is levied at a rate of 40%. If, however, the parent dies within seven years of making the cash gift, the gift is added back into the parent’s estate at death, on a sliding scale basis if death occurs between 3 to 7 years and is taxed at the IHT rate of 40%, if the estate of the parent exceeds the nil rate band (NRB) of £325,000. This nil rate band is given to each parent.

Clearly, if trying to reduce a potential IHT exposure, gifts of cash to the next generation has its benefits if the gift is made at least seven years before death. The problem with direct gifting, however, is that the parents lose control of the cash and if a large sum is gifted this can be a lot of responsibility for a student or young adult. Another option therefore may be to put the gift of cash into a discretionary trust of which the parents retain control by appointing themselves as trustees. A gift of cash into a discretionary trust is free from CGT and if the gift is less than the £325,000 NRB (or less than £650,000 for a joint gift), there will be no tax to pay, assuming again that the parent doesn’t die within seven years of making the gift. If death does occur, the trustees are responsible for paying any IHT which may arise, not the child. Also, if the cash in trust generates interest, this income will be taxed initially in the trust but if distributed it carries a tax credit, in respect of the tax paid by the trustees, and so will ultimately be taxed at the child’s lower basic rate tax band.

A trust may not be cost effective for small cash gifts due to the costs of setting up and running a trust. Trusts can be complex and professional advice should always be sought. Also, discretionary trusts often incur 10-yearly charges and exit charges can also arise when funds are paid out for the benefit of the beneficiaries. These additional trust tax charges, if they arise, are a maximum of 6%. Nevertheless, the use of trusts is often a tax efficient way of reducing IHT exposure and making tax efficient gifts of cash to the next generation, particularly as it allows the parent to retain a degree of control over the cash until it is paid to the child in later years.

The advice above is specific to the facts surrounding the questions posed. Neither FPM nor the contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.