What is a Discretionary Trust?

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Family sitting together in the living room

In the realm of wealth management and estate planning, there exists a nifty tool that can offer remarkable flexibility and control over the distribution of your assets: the discretionary trust.

This type of trust is a popular choice in legal planning for individuals in England and Wales who wish to maintain a level of influence over how their wealth is doled out among beneficiaries, without getting bogged down by overly rigid structures.

So, what exactly is a discretionary trust?

At its core, a discretionary trust is a legal arrangement that allows you to set aside assets for the benefit of one or more beneficiaries, without granting them an immediate or absolute entitlement to those assets. Here’s the nifty bit: you, as the settlor, get to appoint trusted individuals known as trustees, who have the ‘discretion’ to determine when and how the trust’s assets are distributed.

This is what sets it apart from other trust arrangements — with a discretionary trust, your trustees can consider the circumstances of each beneficiary at the time the trust is accessed, and make judicious decisions based on their needs and your wishes.

What’s more, you can establish a discretionary trust while you are still alive, perhaps as a means of gifting or to organize your estate in preparation for the future. Alternatively, you can create one when making a Will, to come into effect upon your passing. Both approaches come with their own strategic benefits, however, the flexibility remains a constant advantage.

Why might you want a discretionary trust?

To provide for uncertain futures: Life is unpredictable. Beneficiaries’ circumstances can change, often dramatically. A discretionary trust allows trustees the flexibility to provide or withhold financial assistance in response to these changing needs or life events.

For control over assets: If you’re hesitant about providing a direct gift to certain beneficiaries – maybe because they’re not the best at managing money, or are going through a turbulent phase – the trust gives you peace of mind. Trustees can ensure that your assets are used sensibly and for purposes you approve of.

Asset protection: Whether it’s safeguarding assets from potential claims, such as those that may arise during divorce settlements* of beneficiaries, or to protect beneficiaries who are vulnerable or incapable of managing their affairs, discretionary trusts can serve as a protective barrier.

Succession planning: Particularly in the context of family businesses or property, these trusts can be invaluable in providing a blueprint for the future, without the necessity of fragmenting asset ownership.

Remember, while a discretionary trust offers numerous benefits and can form an integral part of estate planning, it’s also vital to appreciate the gravity of choosing the right trustees. They will wield considerable influence over your assets, so it’s paramount that these are individuals you trust implicitly to act in the beneficiaries’ best interests.

Without a doubt, the creation and management of trusts are nuanced. It’s not all about tax planning (which I’ll get to later), but also about preserving your legacy in a way that matches your unique situation and objectives. So, while we navigate the legal intricacies, remember that the end goal is to custom-fit your hopes for the future into a legal framework that stands ready to serve your family and your values.

An important caveat

While a discretionary trust holds powerful benefits and can offer a layer of protection over your assets, it’s important to proceed with a word of caution. The autonomy granted to trustees under a discretionary trust does not extend to the realm of family courts. In other words, you cannot simply ‘oust’ the absolute discretion of a court, especially under circumstances involving divorce settlements.

Under section 25 of the Matrimonial Causes Act, courts possess the authority to consider all aspects of a divorcing party’s financial resources. This includes potential entitlements under a discretionary trust. Should the court deem it appropriate, they can factor in future trust distributions when dividing marital assets. Your trust may be considered toward one party’s settlement, even if the trustees have not decided to distribute these assets yet. If anyone tells you money in a discretionary trust is absolutely safe from a divorce settlement, they are lying.

This illustrates the limits of a discretionary trust in safeguarding assets against claims made upon divorce. It also underscores the importance of expert legal guidance when structuring your trust, to align with your intentions while acknowledging the scope of judicial discretion.”

A look at taxation

It is critical to understand the tax implications of both creating and running discretionary trusts. This section isn’t intended to be a comprehensive guide, but just a simple overview of what’s involved.

Entry charge

When you create a discretionary trust, there might be an immediate tax charge, known colloquially as the ‘entry charge’. This applies if the total sum of assets you’re placing into trust exceeds the nil-rate band – your allowance for Inheritance Tax (IHT), which is currently £325,000. The excess is taxed at a lifetime rate of 20%, providing the trust is set up during your life and not on your death. So if you gift into the trust(s) below £325,000 and survive for 7 years, there’s no entry charge or Inheritance Tax consequence. This is a rolling amount, so you can gift it every 7 years.

Exemptions and opportunities

Now, let’s delve into the nuances – special provisions such as the ‘gifts out of income‘. This is indeed an often-overlooked aspect of IHT planning. You’re allowed to make regular gifts out of your surplus income that are immediately exempt from IHT – these do not eat into the £325,000 nil-rate band. The key conditions here are that these gifts must be made out of your income (not your capital), must be part of your normal expenditure, and must leave you with enough income to maintain your standard of living.

These gifts could include payments into a discretionary trust, which may be highly advantageous for those with significant income looking to reduce their IHT exposure while supporting their beneficiaries.

10 year charge

The 10-year anniversary charge applies to both trusts created during a settlor’s lifetime and those established upon death through a Will. So, regardless of when the trust is set up, the trustees need to keep an eye on this charge, as it represents an ongoing tax liability for the trust.

Every 10 years from the creation of the trust, a valuation of the trust assets is required. If the value of the trust’s assets – along with any other chargeable transfers made by the settlor in the seven years before the trust was created – exceeds the IHT nil-rate band (£325,000 as of the last update – the additional RNRB allowance of £175,000 does not apply to discretionary trusts), an inheritance tax charge is levied on the excess at a maximum rate of 6%.

To calculate the exact figure for the periodic charge, a complex formula is applied which considers several factors, including:

  • The value of the trust assets at the 10-year anniversary.
  • Any IHT nil-rate band available (which might be reduced if the settlor made chargeable lifetime transfers in the seven years before setting up the trust).
  • Reliefs and exemptions that might apply (such as business or agricultural property relief).

It’s important to remember that the rate for the 10-year charge is proportionate – it’s effectively 30% of the lifetime rate of 20%, hence why the maximum rate is set at 6%.

Exit Charges

In addition to the 10-year charge, there may also be ‘exit charges.’ These apply when assets are distributed or transferred out of the trust between the 10-year anniversaries. The exit charge is a proportion of the amount charged at the last 10-year anniversary, taking into account the time elapsed since that charge.

Administration of discretionary trusts

There’s quite a bit of paperwork involved with administering a discretionary trust.

Both lifetime (inter vivos) discretionary trusts and those established upon death through a will, known as testamentary discretionary trusts, may come under the requirement to register with HMRC’s Trust Registration Service (TRS), following the expanded rules under the UK’s implementation of the EU’s Fifth Money Laundering Directive. Trusts created by a Will will need to register where the trust still exists following the second anniversary of death. There are potential penalties for non-compliance.

Trustees must keep detailed records of the trust’s assets, income, gains, losses, expenses, and distributions. They need to retain these records to demonstrate that they have fulfilled their tax responsibilities and managed the trust’s assets appropriately.

Creating annual accounts is an essential part of the trust administration process. These accounts should show all financial transactions and the status of trust assets. They may be required for tax filing purposes, or if beneficiaries ask to see them.

Each year Trustees are required to file annual returns with HM Revenue & Customs (HMRC) if the trust generates income or has tax liabilities. This could include income tax from investments, capital gains tax if assets have been sold at a profit, or inheritance tax due to the 10-year anniversary charge or exit charges.

If there are taxes due, trustees must calculate the amounts, report them accurately to HMRC, and ensure they’re paid by the relevant deadlines.

In addition to tax responsibilities, trustees must comply with various other regulations. This may include anti-money laundering regulations and other statutory requirements.

Given the complexities and responsibilities trustees face, many opt to hire professionals such as accountants, solicitors, or specialist trust administrators to assist with the ongoing administration of the trust.

Is a discretionary trust right for me?

A discretionary trust is a powerful tool in estate planning, but it’s not a one-size-fits-all solution. It’s crucial to consider your circumstances and goals before deciding whether establishing one is the right move for you.

If the idea of leaving your estate to particular individuals outright doesn’t sit well with you—perhaps due to concerns about their money management skills or vulnerability to external claims—a discretionary trust stands out as a smart option. This vehicle empowers your appointed trustees to make considered decisions about distributions, based on the individual circumstances and needs of your beneficiaries at any given time. The trust can be a safeguard, a means to protect those you care for from their own inexperience or from life’s unforeseen challenges.

The strategy of funding the trust with surplus income is something to consider for individuals with spare cash each month. It allows for a smooth, tax-efficient transfer of wealth that won’t impact your lifetime nil-rate band for IHT purposes or require surviving a seven-year period for the contributions to fall entirely out of your estate for tax purposes—a substantial benefit indeed.

However, these positives are balanced against certain inevitabilities, notably the ongoing administrative obligations and tax charges. From keeping meticulous records to managing the 10-year IHT charge, the administrative load is not trivial. Tax reporting, accounting, and compliance with other statutory requirements demand attention and expertise. For these reasons, many trustees lean on professional advisers to help keep the gears of the trust turning smoothly. For this, there is a cost.

Pragmatically, a discretionary trust is not ideal for everyone. The financial threshold for justifying a trust’s creation and sustained operation is significant. The set-up and ongoing costs must be measured against the value of the assets involved. For smaller estates, the resources required to maintain a discretionary trust may overshadow the advantages.

In conclusion, the decision to establish a discretionary trust should be based on a comprehensive evaluation of your assets, family dynamics, and succession goals. Of course, these are best discussed with a solicitor experienced in Private Client matters.

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