PROFIT EXTRACTION - 03.02.2011

Paying for your child’s education

School fees are expensive, especially when you have to pay for them out of your taxed income. But if you can involve your family in some tax planning, is there a way to extract tax-free money from your company to pay the fees?

Tax cost

If you’ve built up your business through hard work, we don’t need to tell you how disheartening it is to see a large chunk of it disappear into the Taxman’s coffers whenever you take money out of your company. And the more you draw, the proportionately greater your tax bill. For example, if you want to pay yourself extra income to cover your child’s school fees, say £16,000 per year, the most tax-efficient way to do this is usually to vote yourself a dividend. But even this can cost you up to £5,777 in higher rate tax. So is there an alternative?

Child trust solution

One ploy would be to divert income to your child by giving them shares in your company. Assuming your child has little or no other income, they wouldn’t have to pay a penny in tax on the dividends they receive. So using the example above, the tax bill of £5,777 would disappear completely. The trouble is that the so-called tax “settlement rules” say that a gift to your own child is ineffective for income tax - the Taxman would simply ignore it and treat any dividends paid as your income - putting you back at square one.

Not a gift

One couple, Mr and Mrs Bird, thought they had a way around the settlement rules; they wouldn’t give their children shares, instead they would make them pay for them with money the kids had accumulated from gifts from grandparents etc. They believed that as the shares weren’t a gift the settlement rules wouldn’t apply. Unfortunately for the Birds, the Taxman, and the subsequent tribunal, disagreed. The transfer of the shares gave the children a right to future income from their parents’ company and this was enough to trigger the settlement rules. So is shifting dividends to your kids to save tax a non-starter?

Family (tax) planning

You need to think wider. For example, is the time right for your parents to consider making gifts as part of their Inheritance Tax planning? If so, there’s some good news; the settlement rules don’t extend to gifts from grandparents to grandchildren. It would be OK for them to purchase shares in your company and then give them to your children. These can be held in a trust until your youngsters reach 18. A simple bare trust will be fine (see The next step). When the dividends are paid they’re tax-free for the trust (up to around £43,000), and it can use the money to pay the school fees.

Procedure

Your company can create new shares for the grandparents to buy. But to avoid other tax problems they must buy them at full market value (see The next step).

Tip. So that the level of dividends for the trust can be tailored to meet its needs, your company can issue a new class of shares just for the grandparents. This means your company can declare a dividend specifically for the grandparents without the need to pay other shareholders, e.g. yourself.

For information about bare trusts (TX 11.09.03A) and for information on the market value of shares (TX 11.09.03B), visit http://tax.indicator.co.uk.
Dividends from shares you give to your child are caught by the Taxman’s settlement rules, so you’ll pay the tax on these. But gifts from grandparents are not. Create new shares in your company which the grandparents buy and give to a trust to benefit your child. The dividends it receives will be tax-free up to £43,000.

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