Aileen Keogan Solicitor, McCann FitzGerald
Tracey O’Keeffe Solicitor, McCann FitzGerald
November 2007
There is an age-old problem presented by clients regarding how to provide for their offspring on their deaths, where the parents wish an inheritance to pass to their children in a Tax Efficient manner yet wish to protect their children from inheriting at an immature age. Typically, the parents wish to provide that, after provision for the surviving spouse, the children should not inherit until each is aged, say, 25, 28 or even 30.
The implications of taxes and protection for children and young adults have not been considered in any great detail to date as, fortunately, it is rare for both parents to die while their children are young. However, this will become more relevant because of separation/divorce where a sole parent wishes to provide for his or her children on their death alone. It is also becoming relevant as clients with significant wealth now often wish to provide that their spouse will take only part of their estate on death, with part passing to the children while the spouse is still alive. There are, therefore, more instances of children inheriting at an age where they require protection, i.e., on the death of one parent only.
However, the marriage of tax efficiency and protection is not easy, and a balance needs to be drawn between them having regard to what is best for the family as a whole.
Favouring Tax Efficiency over Protection — the Bare Trust
The most Tax Efficient method of taking an inheritance is to give it to the child so that he takes it absolutely, i.e., without any age restriction, trust or condition. The inheritance is held in a bare trust when the child is still under 18. However, this type of trust provides the least protection for the child.
Legal effect
The legal effect of this for a child is that, as the child cannot give a valid receipt to the executor until he “comes of age” at 18, the inheritance is protected from the child in a bare trust until that age 18. However, once 18, the child is entitled to call on the executor(s) (as bare trustee(s)) to hand over the inheritance to him, which the child can then invest or spend as he so wishes. Most parents would be concerned that a child is not sufficiently mature at that age to receive an unrestricted inheritance.
While the child is under the age of 18, the bare trustee(s) can apply the inheritance for the benefit of the child, e.g., for living expenses, education, etc. It is sensible to provide, in a will of this nature, that the bare trustee(s) is given significant powers to invest the inheritance and apply it for the child’s benefit while under the age of 18.
Tax effect
The tax effect of this is that for CAT, CGT and income tax purposes the child is deemed to inherit the asset at the date of death of his parent and is taxed accordingly.
For CAT purposes the usual tax-free threshold (€496,824 in 2007) is applied to the value received, and the balance is subject to inheritance tax at 20%. At age 18, when the inheritance is handed over to the child (indeed, on any use of the inheritance for living expenses while the child is under 18), there are no further CAT taxes owing as it has been the child’s from the beginning.
Turning 18 is not a taxable event for CAT, CGT or stamp duty purposes.
The child is assessed for income and capital gains tax purposes on the income or gains made by the bare trustee(s) during the period that the child is under the age of 18. The bare trustee(s) pays any such tax on the child’s behalf. See Appendix 1 for an example of a bare trust.
Advantage
The principal advantage to this type of inheritance is the fact that the tax is paid immediately. This has a tax advantage, if one assumes that the net inheritance would be invested in a manner that would produce a better return than the Consumer Price Index (on which the indexation of the CAT tax-free thresholds is based). If so, it seems better to pay tax early on a lower amount that is then invested, than to wait until age 18 and pay the tax on a higher inheritance (because of investment) without a significantly higher tax-free threshold.
However, some speculate that, if the tax-free threshold is increased significantly above inflation (as occurred in December 1999, when there was an increase from IR£192,900 to IR£300,000), the investment returns might not outweigh the increase.
Disadvantage
The principle disadvantage to this method of providing for a child is that there is no restriction in legal terms on the child taking (and spending) their inheritance at age 18. Many young adults are not sufficiently mature at this age to handle an inheritance of significant value.
Favouring Protection over Tax Efficiency — the Discretionary Trust
Despite the fact that discretionary trusts are considered to be tax avoidance structures (hence the additional taxes imposed on them to discourage such use), they are the best way of protecting children from taking an inheritance until each child is sufficiently mature to do so.
Legal effect
Under such trusts the parents select trustees whom they trust to make the judgement call on the level of maturity of each child. The trustees will appoint trust assets to the children at their absolute discretion. Indeed, who to appoint as trustees is often the most difficult matter that the parents need to decide on when making their wills. The parents can give general guidance to the trustees in a letter of wishes setting out the parents’ views regarding when to expect maturity, etc.
Tax effect
The tax effect of this is that the child is deemed to inherit the asset at the date of the appointment of the trust assets to him on the exercise by the trustees of their discretion and is taxed accordingly. The usual tax-free threshold (€496,824 in 2007) is applied to the value received by the child, and the balance is subject to inheritance tax at 20%. However, if the trustees provide for the child’s living expenses, education, etc., before the final appointment of the trust fund to him, there are also tax consequences as these would also be treated as taxable inheritances (unless they are exempt under s82(4) CATCA 2003 as a payment of maintenance, support or education to a child under age 18 where both parents have died).
Once the youngest child who can benefit under the trust reaches his 21st birthday, if the trust is still in place or to the extent that the trust still applies to certain assets, discretionary trust levies apply (6% initially and 1% per annum thereafter, with a refund of 50% of the initial 6% levy if the trust is wound up totally within five years).
The appointment from the trust to the child is a taxable event for CGT purposes, albeit that usually there is a credit available for any CAT paid. This credit would be lost if the child sold the chargeable assets received by him within two years (s104 CATCA 2003 as introduced in FA 2006). The trustees are assessed for income tax and CGT purposes on the income or gains made by the trust during the period that the assets remain under the discretionary trust, and an additional surcharge of 20% can arise on accumulated income. See Appendix 2 for an example of a discretionary trust.
Advantage
As the child cannot say that he is entitled to an inheritance, because whether he is to receive one at all depends on the discretion of the trustees, the inheritance is protected from the child in a discretionary trust until the trustees exercise their discretion. While the assets remain in the discretionary trust, the trustees can apply capital and income for the benefit of the child, e.g. for living expenses, education, etc.
Disadvantage
Although the parents can hope that older children in the family will have shown sufficient maturity by the time that the youngest child has his 21st birthday so that the trustees will have appointed out their share of the inheritance, this is unlikely to be the case for the youngest child. The difficulty is that the youngest child does not have the same chance as his older siblings to reach maturity without the additional tax cost of the levies.
See Appendix 2 for an example of a discretionary trust.
A Sensible Balance or not? The Fixed Trust
Parents may take the view that there will come a time when their child should have enough maturity or that, even if he never fully matures, the child should still take the inheritance and do what he may with it. Many wills, therefore, provide that a child should take his inheritance at a particular age, typically age 25, in the hope that the extra seven years beyond age 18 would provide each child sufficient wisdom and sense to handle their inheritance.
This often arises where the parents are not comfortable with entrusting trustees with complete discretion over when their child should inherit. Where parents instruct that they would like their child to inherit at a particular age, it should be explained to them that reaching a particular age is not necessarily a guarantee of maturity — should a child take a sizeable inheritance in unrestricted form if he is not able to handle it? There are also “hidden” taxes that make this form of trust quite inefficient for tax.
There are different versions of such fixed trusts, depending on:
whether the income up to the selected age can be accumulated by the trustees or
whether it must be paid to the child.
Legal effect
The legal effect of a fixed trust is that the inheritance is protected from the child until the selected age. Only at that stage is the child entitled to call on the trustees to hand over the inheritance to him to invest or spend as he so wishes. It is sensible to provide in a will of this nature that the trustees are given powers to apply capital for the child’s benefit while under the selected age should a need arise and the income not be sufficient.
Depending on how the will is drafted, while the child is under the age of 18, the trustees can or must apply the income of the inheritance for the benefit of the child, e.g., for living expenses, education, etc. If the trust does not allow the accumulation of income, the income not yet applied to the child at regular intervals from the date of death of the parent to age 18 must be paid out in lump sum at age 18 and all future annual income must be paid out to the child at regular intervals from age 18 on. Therefore the child is not protected from any sizeable income flow from age 18 and will at 18 receive a lump sum of any income not spent up to age 18.
Tax effect
The tax effect depends on the version of fixed trust that applies. If we assume that the selected age is 25, the following applies.
Power to accumulate
Where the trustees have power to accumulate income, the trust is deemed to be a discretionary trust for CAT and income tax purposes (s2(1) CATCA 2003). On the child’s 21st birthday, as there are no other principal objects in the trust discretionary trust levies will arise (6% initially on the child’s 21st birthday and 1% per annum thereafter, albeit that 50% of the 6% levy will be refunded on the 25th birthday). On the child’s 25th birthday the child is deemed to inherit the asset at that date and is taxed accordingly. The usual tax-free threshold is applied to the value received, and the balance is subject to inheritance tax at 20%. The difference between this trust and a discretionary trust is that the trustees here do not have the flexibility to amend the trust to avoid the levies and must therefore pay levies, even if the youngest child is mature at age 21.
In addition, the winding-up of the trust on the 25th birthday is a taxable event for CGT purposes, albeit that usually there is a credit available for the CAT paid (this credit would be lost if the child sold the chargeable assets received by him within two years (s104 CATCA 2003 as introduced in FA 2006)).
The trustees are assessed for income tax and CGT purposes on the income, or gains made by the trust during the period that the assets remain under the trust. The additional 20% discretionary trust surcharge arises on income accumulated. The tax effect is therefore the same as a discretionary trust, although the trustees do not have any discretion to hold back funds from the child at age 25. To the extent that income is paid out, the child is assessed to tax on the income and can claim a credit in respect of tax paid by the trustees. The child is also treated as receiving an inheritance of the amount received, which is subject to CAT (in such a case, concessionary relief should be sought to treat the value of the inheritance as net of income tax).
See Appendix 3 for an example of a fixed trust where the income is accumulated.
No power to accumulate
Where the trustees do not have power to accumulate income, it is Revenue’s view that for CAT purposes the child is deemed to inherit an interest in possession on the death of the parent. In such a case, if the child reaches age 25, this inheritance is ultimately taxed as a limited interest calculated by subtracting from 25 the age of the child at the parent’s death to arrive at a calculation of a period certain (and then applying the rules in Schedule 1, part 1, paragraph 6, CATCA 2003, to arrive at the taxable value). The usual tax-free threshold is applied to the value received, and the balance is subject to inheritance tax at 20%. On the child’s 25th birthday the child is deemed for CAT purposes to inherit a further absolute interest in the trust fund at the value at that date of the trust fund. The child’s earlier fixed interest is aggregated with the absolute interest now taken. The usual tax-free threshold is applied to the value received, and the balance is subject to inheritance tax at 20%. In effect, there is a double charge to CAT on the same assets in the trust. This tax treatment is, however, uncertain as it rests on Revenue’s interpretation of the legislation in light of the case of Jacob (Brigid Kathleen) v Revenue Commissioners [1984] 3 ITR 104, which was settled without fully determining the issue of value.
The trustees are assessed for income tax and CGT on the income or gains made by the trust during the period that the assets remain in the fixed trust. The child is also assessed on the income and can claim a credit in respect of tax paid by the trustees.
Again, the winding-up of the trust on the 25th birthday is a taxable event for CGT purposes, albeit that usually there is a credit available for any CAT paid. This credit would be lost if the child sold the chargeable assets received by him within two years (s104 CATCA 2003 as introduced in FA 2006).
See Appendix 4 for an example of a fixed trust where the income must be paid out.
Disadvantage
The effect of this is that the typical fixed trust is a quite tax-inefficient method, either because of the discretionary trust levies or because of the risk of double taxation for CAT. In any event it does not afford real protection for a child, should that child still be immature at the selected age.
Recommendation
Although it may at first sight seem sensible to advise parents to take the “balanced” view between protection and tax efficiency in providing for their young by adopting a fixed trust structure, in the end such a structure may not afford the tax efficiency that one would assume. Also, given the nature of a fixed trust, the protection is available only until a particular age, whether a child is mature at that age or not. It is therefore more appropriate to suggest to the parents that their assets be divided into certain asset types that would be suitable to put into the Tax Efficient bare trusts and those that should be held back in a discretionary trust. Assets suitable for bare trusts could be those that are already restricted in some other way, whether it be investment assets in joint names with other investors where their consent is required to sell or assets that are subject to mortgages and which require the bank’s consent to sell.
Appendix 1 — Bare trust
Child aged 12 when parents die in 2007.
Assumptions
1. Inheritance valued at €1,000,000 at age 12.
2. Inheritance/net inheritance invested in assets producing a capital return of 6% p.a.
3. Tax-free threshold increased by 3% p.a.
4. Child has not received any prior taxable benefits.
5. Income is paid out for benefit of child each year, i.e., is not invested.
Bare trust
Child is absolutely entitled at age 12 but has no legal access to the fund until age 18.
Appendix 2 — Discretionary trust
A client couple wish to leave everything they own to each other and, after both of them have died, for their entire estate to pass to a discretionary trust with the wish that the trustees of the discretionary trust would in their absolute discretion pass their estate equally to their three children once the trustees decide that the children are sufficiently mature to take an inheritance. Their estate on the second death is valued at €3m. The children are aged 12, 16 and 17 on the second death. The three children have not received any prior aggregable benefits. Each child in effect should receive €1m. The income is used to meet the education and maintenance expenses of the children and therefore is paid out in full with no CAT charge in the hands of the children as such payment is exempt under s82(4) CATCA 2003 (as long as the children are under 18). The trustees resolve that the older children are mature at age 23 and that the youngest child is mature the day before her 21st birthday (to avoid the levies) and appoint out the relevant share of the fund at each particular age.
Assumptions
1. Inheritance valued at €3,000,000 on death.
2. Inheritance/net inheritance invested in assets producing a capital return of 6% p.a.
3. Tax-free threshold increased by 3% p.a.
4. Children have not received any prior taxable benefits.
5. Income is paid out in full for benefit of children each year, i.e. is not invested.
6. The assets consist of “chargeable assets” for CGT purposes which were acquired when the trust was set up and were not disposed of during the term of the trust.
7. The “chargeable assets” which the child receives are not disposed of within 2 years.
Appendix 3 — Fixed trust: income accumulated and paid out in exempt form
A client couple wish to leave everything they own to each other and, after both of them have died, for their entire estate to pass equally to their three children once they turn 23. Their estate on the second death is valued at €3m. The children are aged 12, 16 and 17 on the second death. The three children have not received any prior aggregable benefits. Each child in effect should receive €1m. The income can be accumulated by the trustees, who in fact use it to meet the education and maintenance expenses of the children, and therefore it is paid out in full with no CAT charge in the hands of the children, as such a payment is exempt under s82(4) CATCA 2003 (as long as the children are under 18).
Assumptions
1. Inheritance valued at €3,000,000 on death.
2. Inheritance/net inheritance invested in assets producing a capital return of 6% p.a.
3. Tax-free threshold increased by 3% p.a.
4. Children have not received any prior taxable benefits.
5. Income is paid out in full for benefit of children each year, i.e. is not invested.
6. The assets consist of “chargeable assets” for CGT purposes which were acquired when the trust was set up and were not disposed of during the term of the trust.
7. The “chargeable assets” which the child receives are not disposed of within 2 years.
Appendix 4 — Fixed trust: income must be paid out
A client couple wish to leave everything they own to each other and, after both of them have died, for their entire estate to pass equally to their three children once they turn 23. Their estate on the second death is valued at €3m. The children are aged 12, 16 and 17 on the second death. The three children have not received any prior aggregable benefits. Each child in effect should receive €1m. The income is treated as the children’s under the terms of the will and is paid out in full.
Assumptions
1. Inheritance valued at €3,000,000 on death.
2. Inheritance/net inheritance invested in assets producing a capital return of 6% p.a.
3. Tax-free threshold increased by 3% p.a.
4. Children have not received any prior taxable benefits.
5. Income is paid out in full for benefit of children each year.
6. The assets consist of “chargeable assets” for CGT purposes which were acquired when the trust was set up and were not disposed of during the term of the trust.
7.The “chargeable assets” which the child receives are not disposed of within 2 years.
Aileen Keogan is co-author of The Law and Taxation of Trusts (Tottels, 2007).
