The disadvantage of a discretionary trust is the cost of setting up and running it and the tax position is more complex.
There are two tax consequences of creating a discretionary trust that need to be considered. The most important point is that settlors are almost in all cases restricted to putting £325,000 into a trust because if you transfer into trust more than your available IHT nil rate band, an immediate 20 per cent charge arises on the balance.
Following the creation of the trust, the usual seven year rule applies to avoid any IHT liability on death. During the lifetime of the trust, there are potential charges to IHT every 10 years, at a maximum rate of 6 per cent.
A discretionary trust is also more costly to run, with HMRC compliance, and preparing tax returns each year, but these can be looked on as the price to obtain flexibility over the assets, while potentially saving 40 per cent IHT on £325,000.
A discretionary trust would usually fund payment of the school fees by making distributions to the grandchildren beneficiaries.
This has further tax advantages: while the trustees currently pay income tax at the highest rates on their income arising, on the distribution to a grandchild, that grandchild can recover the tax paid by the trustees if, as is usually the case, they have no other income.
Discretionary trusts also have capital gains tax advantages. If, for example, you have an existing share portfolio payment of gains that you wish to use to fund school fees, there will be a CGT liability if you were to sell it to raise funds to make a gift, or a liability if you were to gift the funds away to children and/or grandchildren for them to liquidate.
If those shares are transferred to a discretionary trust, CGT can be deferred until they are actually sold. Furthermore, shares can then be transferred out to the grandchild beneficiary and sold on his or her behalf to take advantage of their annual exemptions, significantly reducing the overall CGT bills.
Areas of concern
If grandparents are hoping to make use of these options, it is important that everyone is aware of what could go wrong.
It is obviously important before starting out on this process to review your financial position and be confident you can afford to maintain what could be a 15-year commitment. Even if you are comfortable that the figures stack up now, what would happen if, for example, you needed to fund expensive nursing care in future?
