Discretionary Trusts

Trusts are becoming a popular way for people to plan and protect their wealth. There are many different ways to use trusts and many different types, so it's important to seek help from a reputable financial adviser for your specific circumstances. This article focuses specifically on Discretionary Trusts, including the benefits, drawbacks and tax implications. 

What is a Discretionary Trust?

A Discretionary Trust is an arrangement that gives trustees flexibility and control over how best to use the trust assets for the benefit of the beneficiaries.

When you set up a Discretionary Trust, you identify a class of beneficiaries such as children and/or grandchildren who can receive capital and/or income from the trust at the discretion of the Trustees. No one beneficiary has an absolute entitlement to either income or capital.
 
This flexibility helps in situations where children or grandchildren may not yet be born at the time the trust is set up, as they would therefore automatically be included as a beneficiary.

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Who can benefit from using a Discretionary Trust?

Discretionary Trusts are commonly set up to put assets aside for children and/or grandchildren for a future financial need or as a protective measure for a vulnerable family member who may be unable to manage their own finances. 

What are the drawbacks to using a Discretionary Trust? 

Control of assets

The Settlor (the person who puts assets into trust) would lose control of their assets at the point they are transferred to a trust; the assets would therefore fall under the control of the trustees who must manage them in accordance with the Trust Deed. It is not normally possible for assets to be transferred back to the settlor, therefore it is important that you are certain how to proceed before creating a trust. 

Administrative burden

Setting up a Discretionary Trust can be complex, but maintaining a trust of this nature on an ongoing basis can bring about further administrative burden and cost. Trustees should hold meetings on a regular basis, annual accounts and tax returns may need to be completed, and Trustees may have to seek additional legal, accountancy or financial advice. 

Discretionary Trusts and tax

When considering the use of a Discretionary Trust it's important to understand the tax implications that might affect you, such as; Inheritance Tax, Income Tax and Capital Gains Tax. 

Inheritance tax

Discretionary Trusts are within what is known as ‘the relevant property regime’ which means they are subject to inheritance tax which can add a degree of complexity. 

Any gifts into a Discretionary Trust arrangement are classed as Chargeable Lifetime Transfers (CLTs) if they don’t fall within one of the exempt gift categories, which means they can be immediately chargeable to inheritance tax.

When these gifts are added to any other CLTs made within the last 7 years, if the total value exceeds the Nil Rate Band (currently £325,000 for the 2024/25 tax year) there will be an immediate charge to inheritance tax on the excess over the Nil Rate Band. This charge is 20% if paid by the trustees, or 25% if paid by the settlor.

For example: Assuming you have not made any other CLTs in the previous 7 years, if you gifted £400,000 into a Discretionary Trust, there would be an immediate charge of 20% on £75,000 which would equate to £15,000 which the trustees would pay.

There can also be further complexity from an additional inheritance tax charge assessment that has to be carried out on every ten year anniversary of the trust. If tax is due, the maximum rate is 6% of the trust value over the Nil Rate Band. There can also be time apportioned ‘exit’ charges on capital distributed out of the trust, again when the value is in excess of the Nil Rate Band.

For example: Judith decides to transfer £325,000 cash into a discretionary trust for the benefit of her children. Judith has made no other gifts or transfers in the last seven years. There is no immediate charge to inheritance tax as the value is within the Nil Rate Band. After 10 years, the cash has been invested and is worth £500,000. Assuming the Nil Rate Band is still £325,000 there would be an inheritance tax charge of £10,500.

Income tax

Trustees are responsible for paying tax on income received in a Discretionary Trust. Income within the trust is charged at the additional rate of 45% (39.35% for dividend income). A trust that accrues income that does not exceed £500 p.a. from 2024-25 will have this income written down to £0 for tax purposes. Again, this £500 limit is apportioned across all trusts created by the settlor, subject to a de minimis limit of £100 p.a. per trust.

If the trust’s income exceeds £500 p.a. from 2024-25, all income is assessable for income tax.

Any income distributed to beneficiaries is accompanied by a 45% tax credit and so some or all of it may be available for a tax reclaim by the beneficiary.

Capital Gains Tax

Trustees may have to pay Capital Gains  if they sell or transfer assets on behalf of the beneficiary. Like individuals, Discretionary Trusts also have an annual exemption to Capital Gains, however this is capped at £1,500 (for the 2024/25 tax year). Effective from 30 October 2024, capital gains above the trust's annual exemption are charged at 24%.¹

Is a Discretionary Trust right for me?

If you want to establish a trust for a class of beneficiaries such as your children or grandchildren and retain control over the funds you gift, then a Discretionary Trust may be an appropriate solution for you.

You do, however, need to be aware of the additional complexities in respect to trustees’ duties, including being aware of the way the trust is treated with regards to taxation and the administrative burden. 

With so many different types of trust arrangements in existence, it can be extremely challenging to decide if a trust is the best solution for you, or equally, which trust would be most suitable given your requirements. Why not let us help you?  We have decades of experience in helping people choose the right arrangement for passing on wealth and are here to help. Please do not hesitate to contact us.

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The Financial Conduct Authority does not regulate estate planning, tax advice, wills or trusts.

References 

¹Where a Settlor has created more than one trust the standard income tax band and capital gains trust annual exemption are shared between the settlements. While a Settlor can create an unlimited number of Trusts the income tax band and CGT annual exemption will be divided by a maximum of 5.