What is a Discretionary Trust?
A Discretionary Trust is a trust that leaves the distribution of trust property (either capital, income, or both) to the absolute discretion of the trustees.
As with other will trusts, the standard discretionary will trust does not come into effect until the testator dies, at which point the trust is set up and the assets are appointed into the trustees’ names. Trustees have the right to retain and hold assets, or to distribute some or all assets to anyone from a given list of named beneficiaries, as they see fit. These beneficiaries are chosen by the testator, but they have no absolute right to inherit from the trust. Instead, they are “potential” beneficiaries, who stand to inherit only if the trustees decide to make distributions of capital or income.
Because of the extent of these discretionary powers, a letter of wishes must always be created to help the trustees understand the testator’s intentions and the rationale behind the creation and running of the trust.
In what circumstances would you consider a Discretionary Trust?
Owing to the wide-ranging powers conferred to trustees, discretionary trusts offer a great deal of flexibility to cater for changes in the circumstances of beneficiaries. Such circumstances cannot always be foreseen at the time of creating the will, making the discretionary trust a powerful planning tool for clients with concerns about particular beneficiaries.
Example concerns that may lead you to suggest a discretionary trust include:-
Where one or more beneficiaries cannot or should not be trusted to handle large sums of money, the trustees can instead ensure that funds are used appropriate and safely on their behalf.
Where it is likely that one or more beneficiaries may be involved in divorce proceedings, then passing their share(s) into a discretionary trust can sometimes prevent these being included in financial settlements. Note, however, that the court has the power to set aside such transfers if it deems it appropriate.
Where the testator intends to make a series of lifetime gifts to beneficiaries and they would ultimately wish for them to receive an equal amount. Rather than keeping the will up to date, the trustees can instead assess the position at death and make the appropriate decisions.
Where the testator wishes to benefit a qualifying disabled beneficiary, but they do not want to create a Disabled Person’s Discretionary Trust). See below.
OR
Where the intended vulnerable beneficiary does not qualify for special tax treatment in respect of trusts for disabled persons as set out in s89 (4) of the Inheritance Tax Act 1984, but the testator still considers them incapable or handling their own funds. Trustees can then apply funds in an appropriate manner or purchase items directly for the beneficiary.
Trustee selection
Careful selection of trustees is vital for all types of discretionary trust. The testator should take into account the following;
The size and complexity of the trust: will trustees be capable of managing funds, completing tax returns, arranging and minuting trustee meetings, seeking legal advice etc. ?
The likely duration of the trust needs to be considered in respect of the trustees’ ages.
The trustees should have good, fair relationships with all of the beneficiaries.
The trustees’ honesty should be unimpeachable: are they loyal to the testator and likely to act in good faith while following the wishes of the deceased?
Using a single trustee should be avoided.
Consideration should also be given to trustees’ relationships with one another.
Careful consideration of the potential for a conflict of interest to arise should be given before a beneficiary is also appointed as a trustee.
Tax Treatment
The taxation of discretionary trusts is complex. Here are some of the main points:
A standard discretionary will trust is effectively treated as a non-exempt beneficiary: the value of assets passing into the trust will be deducted from the testator’s available nil rate band, regardless of who the listed beneficiaries of the trust are. Inheritance tax on the estate, if it is chargeable, is paid before assets are transferred into trust.
Discretionary Trusts are subject to Relevant Property Regime charges. This means that any sum within the trust that is above the nil rate band will be taxed up to 6% every 10 years. This is called the ‘principal charge’ or the ‘anniversary charge’.
There are exit charges applicable to capital sums withdrawn if the trust capital remains over the NRB. These are based on the time elapsed since the previous principal charge, the value transferred, and other factors. This charge never exceeds a rate of 0.6% per annum.
Trust income is taxed at the rate of 45% on annual income over £1,000; income below that is taxed at the basic rate.
Capital Gains Tax will be charged on assets exiting the trust which have made a chargeable gain over the current allowance.
No beneficiary is seen to own any of the trust assets for as long as they are held in the trust, so the trust value should not affect their individual taxable estates.
Assets settled into a discretionary trust will not qualify for the RNRB, regardless of whether or not the beneficiaries of the trust are lineal descendants of the settlor. Please contact APS for more details.
A qualifying Disabled Person’s Discretionary Trust escapes the principal/anniversary and exit charges described above, but at the cost of flexibility. Since these charges only apply where trust funds exceed the nil rate band, it can often be beneficial to instead use a Standard Discretionary Will Trust for the benefit of a disabled beneficiary provided that the total funds settled will be less than the nil rate band. Contact RJT Wills for more details
