People are increasingly using trusts to plan for and protect their wealth. Because there are so many different ways to use trusts and so many different types, it’s critical to seek advice from a reputable financial consultant for your individual situation. This article focuses on Discretionary Trust, including their advantages, disadvantages, and tax implications on inheritance tax.
What is a Discretionary Trust?
A Discretionary Trust is an arrangement that offers trustees freedom and discretion over how the trust assets are used for the benefit of the beneficiaries.
When you create a Discretionary Trust, you name a class of beneficiaries, such as children and/or grandchildren, who can receive capital and/or income from the trust at the Trustees’ discretion. No one beneficiary has an absolute right to income or capital.
This flexibility is useful in cases when children or grandchildren have not yet been born at the time the trust is established, as they would be automatically included as beneficiaries.
Who is a Discretionary Trust useful for?
Discretionary trusts are widely used to set aside assets for children and/or grandchildren in the event of a future financial need, or as a safeguard for a vulnerable family member who may be unable to handle their own affairs.
How Does a Discretionary Trust Work?
A Discretionary Trust can be established in England and Wales by an individual or couple (referred to as the Settlor or Settlor’s), who then appoints two or more Trustees to manage the assets for a number of prospective beneficiaries.
You can create a Discretionary Trust during your lifetime, or you can include it in your Will so that your desires are carried out in the event of your death.
As a settlor, you can include a Letter of Wishes in your Will. This effectively serves as instructions to your selected Trustees, instructing them on when and under what conditions your beneficiaries should receive assets. A Letter of Wishes, on the other hand, is not a legally binding document, and your Trustees are not legally required to follow its contents. They can nevertheless intervene at their discretion, for example, if they believe a beneficiary is insufficiently responsible to receive the assets.
The Advantages of Discretionary Trust
There are numerous reasons why you might want to establish a discretionary trust. Some of the potential benefits are listed below, however, many will depend on your circumstances and what you want the trust to accomplish.
#1. Lowering the monetary value of your estate
In most situations, putting assets into a discretionary trust during your lifetime will serve to remove those assets from your estate, lowering the value of your estate when it is assessed for inheritance tax (IHT) at the time of your death.
While it may be easier to reduce your estate value by making gifts during your lifetime, there may be times when transferring an asset into a discretionary trust is preferable – for example, if you want several people to potentially benefit from the asset rather than giving the asset to a specific individual outright.
#2. Providing for beneficiaries while retaining ownership of trust assets
In some cases, you may want to provide for specific loved ones without giving them the assets right now. It’s possible that you want your chosen trustees to have control over the trust’s assets.
For example, you may believe that your children or grandchildren are not mature enough to handle large sums of money, or you may prefer not to give presents to children whose estates would face extra IHT following their deaths.
A less usual scenario is when you want to provide for beneficiaries who are going through bankruptcy or divorce. If you give the assets to those beneficiaries or create certain other types of trusts, the beneficiaries will be viewed as owning the trust assets, making them vulnerable to being taken away or split out.
#3. Flexibility
Creating trust is frequently part of a long-term financial plan. Without knowing what the future holds, it can be difficult to determine which of your beneficiaries will require the trust assets the most in the future. A discretionary trust allows your trustees to select when and how the trust assets and income are distributed to the beneficiaries, potentially assisting your loved ones in ways you did not anticipate when you established the trust.
Similarly, a discretionary trust allows you to care for beneficiaries you may never meet, such as great-grandchildren or even further distant descendants. When establishing the trust, you can name a “class” of beneficiaries (for example, “all of my grandkids who reach the age of 21”). This means you can help people without having to name them all.
The Disadvantages of Discretionary Trust
#1. The trust may provide no benefit to some beneficiaries.
Because trustees of a discretionary trust have the authority to pick which beneficiaries receive trust assets, they can decide that one or more beneficiaries should get nothing. While this may be consistent with your purposes for the trust, you should examine the implications for the possible beneficiaries. It may cause jealousy and even legal wrangling among your loved ones.
#2. Trustees are entrusted with a great deal of authority.
The appointed trustees have a lot of power in discretionary trusts. This makes it much more necessary than usual to carefully select your trustees.
#3. Complexity
The complexity of administering a discretionary trust is related to the preceding consideration. You might think that managing a discretionary trust would be too difficult and time-consuming for your friends and family, as opposed to a simpler structure. This could imply hiring at least one professional trustee alongside them, which, of course, will incur additional expenditures. Even with inexperienced trustees, the more effort necessary to administer a trust, the greater the administration costs. All of these factors can reduce the value of trust. Having said that, there are times when hiring a professional trustee makes sense.
#4. Taxation
For discretionary trusts, taxes can be a double-edged sword. Setting one up may decrease IHT on your own estate, but in some cases, a discretionary trust will be taxed as its own separate entity, meaning the trust will have to pay tax on the assets it holds. More information is provided below, but it is crucial to note that discretionary trusts can both save and incur tax.
Incorporating a Discretionary Trust into your Estate Plan
If you form a discretionary trust in your Will, it is likely to be referred to as a will trust,’ though any sort of trust can be a will trust if it is made in a Will.
Discretionary Will trusts may be exempt from taxation under the applicable property regime. Any distributions made within the first two years after a person’s death are exempt from exit taxes because they are viewed as if they were made in the person’s Will. This implies that if your trustees decide that running the trust is not in the best interests of the beneficiaries after your death, they can dissolve the trust and give all of the assets to the beneficiaries. There would be no charges to the trust under the appropriate property regime if all of this was completed within two years.
A discretionary trust in a Will may also qualify for a different IHT status from the date of the person’s death if the trustees opt to establish a different sort of trust for the dead person’s minor children, for example. This would not be considered “relevant property” (as defined above) and so would not be taxed under the relevant property regime.
Tax and Discretionary Trust
When contemplating the use of a Discretionary Trust, it is critical to understand the tax issues that may apply to you, such as Inheritance Tax, Income Tax, and Capital Gains Tax.
Discretionary Trust and Inheritance Tax
Discretionary Trusts fall under what is known as “the relevant property system,” which means they are liable to inheritance tax, which might complicate matters.
If a donation into a Discretionary Trust arrangement does not fall into one of the exempt gift categories, it is classified as a Chargeable Lifetime Transfer (CLT), which means it is immediately chargeable to inheritance tax.
When these gifts are joined to any other CLTs made within the last 7 years if the total value exceeds the Nil Rate Band (currently £325,000 for the 2022/23 tax year), inheritance tax will be charged on the excess. If the trustees pay it, it will cost 20%, and if the settlor pays it, it will cost 25%.
For example, if you gave £400,000 to a Discretionary Trust and had made no other CLTs in the previous 7 years, there would be an upfront charge of 20% on £75,000, which would equate to £15,000 inheritance tax that the trustees would pay.
An additional inheritance tax charge assessment that must be performed on the trust’s ten-year anniversary can add to the complexity. If tax is owed, the maximum rate is 6% of the trust value in excess of the Nil Rate Band. When the value of the capital distributed out of the trust exceeds the Nil Rate Band, there may be time-apportioned ‘exit’ costs.
For instance, Judith decides to put £325,000 in a discretionary trust for the benefit of her children. In the last seven years, Judith has made no other gifts or transfers. Because the amount falls inside the Nil Rate Band, there is no immediate charge to inheritance tax. The money has been invested for ten years and is now worth £500,000. Assuming the Nil Rate Band remains at £325,000, an inheritance tax levy of £10,500 would apply.
Tax on earnings
Trustees are personally liable for paying taxes on income received from a Discretionary Trust. Once the regular rate band of £1,000 is exceeded, income within the trust is charged at an extra rate of 45 percent (38.1 percent for dividend income). Income in this range is taxed at the standard rate of 20%. (7.5 percent for dividend income). Any income provided to beneficiaries is accompanied by a 45 percent tax credit, so some or all of it may be available for tax reclaim by the beneficiary.
Capital Gains Tax
If trustees sell or transfer assets on behalf of the beneficiary, they may be required to pay Capital Gains Tax. Discretionary Trusts, like individuals, get a yearly exemption from Capital Gains Tax, however, this is capped at £6,150 (for the 2022/23 tax year). Capital gains in excess of the trust’s yearly exemption are taxed at a rate of 20%. (28 percent for residential property).
Is a Discretionary Trust appropriate for me?
A Discretionary Trust may be a good choice for you if you wish to establish a trust for a specific class of beneficiaries, such as your children or grandchildren while retaining control over the monies you gift.
You do, however, need to be aware of the added intricacies of trustees’ tasks, such as how the trust is considered in terms of taxation and administrative costs.
When Is It Legal To Create A Discretionary Trust?
You can put it up during your lifetime or include it in your Will to take effect after you die. If you create it while you’re still alive, keep in mind that it may be subject to inheritance tax if you die within 7 years. Any lifelong donation into a trust that exceeds the £325,000 inheritance tax threshold will be taxed at 20%. There may be further tax breaks available to you.
Discretionary Trust FAQs
What is the difference between testamentary and discretionary trust?
A Discretionary Trust or Deed Trust can be established at any time and used for a number of reasons, but a Will Trust or Testamentary Trust can be established only after the creator of the Will has died.
Is a discretionary trust a good idea?
Discretionary trusts can be quite beneficial in a variety of situations. They can be adjusted to meet your and your family’s needs while also benefiting your estate as a whole. They are useful for protecting assets for beneficiaries who are unable to manage their own funds.
Who controls a discretionary trust?
True control in a modern discretionary trust is held not by the trustee, but by the Appointor — the person who has the authority to dismiss or appoint the trustee.
What happens to a discretionary trust when the settlor dies?
The Settlor’s right to the Trust Fund will be terminated. The Trust Fund will subsequently be held for the Beneficiaries’ benefit.
