A discretionary trust allows the trustees to decide how and when to distribute the funds to the beneficiaries. It is a legal arrangement where assets are managed by trustees for the benefit of one or more beneficiaries. As a flexible vehicle for estate planning and asset management, a discretionary trust offers adaptability in managing and distributing assets according to changing circumstances. This article will cover what a discretionary trust is, its features, benefits, drawbacks, tax implications and more.
Key Points of a Discretionary Trust
- A discretionary trust gives flexible asset distribution, where trustees, through their discretionary powers, can manage the funds based on the beneficiaries’ needs without the beneficiaries having a direct legal claim to the assets.
- Discretionary trusts are great for asset protection and estate planning, protecting assets from creditors and legal claims and avoiding probate for distribution.
- Discretionary trusts are complex and require careful planning especially on tax implications, so professional advice is needed to ensure compliance and management.
- Key roles in a discretionary trust include the trustees, who manage and distribute the assets; the beneficiaries, who may benefit from the trust; and the settlor, who establishes the trust and sets its terms.
A discretionary trust is a powerful financial tool that protects the trust fund and benefits selected individuals. Unlike other trusts, the trustees have full discretion over the distribution of funds, providing greater power to trustees to determine the timing and amount of funds distributed to beneficiaries.
One of the best features of a discretionary trust is its flexibility. Trustees can decide on the timing and amount of distribution based on their judgment and the beneficiaries’ changing needs, allowing for better asset management and fund allocation. It is important that trustees make informed decisions when managing and distributing trust assets to ensure optimal outcomes for the beneficiaries.
Beneficiaries don’t automatically have rights to the income or capital in a discretionary trust. Although beneficial ownership is with them, they don’t have direct control over the distribution. This setup emphasizes the trustees’ control, so the funds are used wisely and responsibly, and trustees must act in the best interests of the beneficiaries. Trustees may also need to protect the trust from the poor life choices of beneficiaries.
Features of a Discretionary Trust
A key feature of discretionary trusts is the flexible distribution. Trustees manage the trust’s assets, also known as trust property, and have discretion over their allocation. They can allocate assets based on the beneficiaries’ changing needs, deciding the amount and timing of distribution for tailored financial support.
Additionally, trustees have the ability to accumulate income by withholding distributions and retaining the income generated within the trust, offering flexibility in managing the trust’s financial benefits while considering tax implications. Trustees can choose to distribute income to beneficiaries or add it to the trust’s capital, impacting the overall value and investment potential of the trust.
Discretionary trusts can have a wide range of potential beneficiaries, who may benefit at the trustees’ discretion and are not automatically entitled to the trust property.
Asset protection is another feature. Discretionary trusts protect assets from creditors or divorce settlements, protect the beneficiaries’ interest and allow them to pass the assets efficiently. This makes them great for shielding wealth from legal challenges and preserving for future generations.
The flexible nature of discretionary trusts allows them to adapt to changing circumstances, making them a valuable tool for estate planning and asset management.
Benefits of a Discretionary Trust
Setting up a discretionary trust has many benefits especially on asset protection. By keeping assets away from business creditors or a divorcing spouse, these trusts ensure wealth stays intact and used for its intended purpose. Trustees have the discretion to distribute assets to beneficiaries as needed, providing flexibility in asset protection. This is especially useful for estate planning, from unnecessary depletion of assets.
Another benefit is the ability to set rules for the fund usage. Discretionary trusts allow for specific criteria for distribution, so funds are given to beneficiaries according to their needs. Beneficiaries may benefit from the trust at the trustees’ discretion, ensuring support is tailored to individual circumstances. This is especially helpful for families and individuals who can’t manage their own funds.
Also, assets in a discretionary trust are not part of the estate, so no probate. This speeds up the distribution and reduces legal and administrative costs. Setting up a discretionary trust ensures the beneficiaries get their inheritance on time and efficiently. Trustees often consider the settlor’s wishes when making decisions about how to distribute assets, ensuring the trust is managed in line with the creator’s intentions.
Disadvantages of a Discretionary Trust
While discretionary trusts has many benefits, it also has drawbacks. One major concern is the lack of control the beneficiaries have over the distribution. Since the trustees have full discretion, the beneficiaries may not get what the settlor intended, resulting to disputes and dissatisfaction. Appointing professional trustees can help ensure impartial and effective trust management, reducing the risk of conflicts and mismanagement.
Another disadvantage is the complexity of setting up a discretionary trust. The process requires thorough planning and legal knowledge, which can be overwhelming for those not familiar with trust law. Also, there’s a risk that the trustees will use the trust for their own benefit, so it’s important to choose trustworthy and impartial trustees.
Discretionary trusts is subject to a more complex tax regime than other types of trusts, and the income from these trusts is taxed differently from personal income. This means trustees must understand and comply with specific tax rules that apply to trust assets and income. Professional advice is necessary to navigate these complexities and ensure tax efficient trust operation.
Tax of a Discretionary Trust
Discretionary trusts have many tax implications, including inheritance tax, income tax, and capital gains tax, each with significant financial impact. Discretionary trusts can offer tax benefits and tax advantages by allowing income or capital gains to be distributed to beneficiaries in lower tax brackets. Trustees are required to complete annual accounts and tax returns, indicating the potential complexities and costs involved in managing the trust on an ongoing basis. Trustees must comply with specific tax rules and understand the available tax reliefs and exemptions to optimize tax efficiency. Professional advisors are necessary to ensure discretionary trusts are tax efficient and comply with the legal requirements. The terms of the trust, as set out in the trust deed, determine how the trust is managed and how tax liabilities are calculated.
Inheritance tax implications are especially important. Discretionary trusts may incur a tax charge at various stages, such as on creation (entry charge), on periodic assessments every 10 years (periodic charge), and on exit charges when assets are distributed. Both the income generated by the trust and the assets held within it may be considered for IHT purposes. Gifts to discretionary trusts are considered chargeable gifts and may impact the settlor’s estate for IHT purposes.
Trustees will pay income tax on the trust income at trust rates. For discretionary trusts with total income over £500, the tax rates are very high, 45% for all sources or 39.35% for dividends. Tax reliefs, such as business property relief and agricultural property relief, may be available to reduce inheritance tax, capital gains tax, and income tax liabilities.
Capital gains tax is another consideration, with annual exemption and specific rates for property and other assets.
Inheritance Tax
Inheritance tax planning (IHT) is a big consideration for discretionary trusts. Discretionary trusts are treated in a specific way for IHT purposes, affecting how assets are taxed both on transfer into the trust and during the trust’s existence. Agricultural relief can reduce the value of eligible assets transferred into a trust, thereby potentially lowering the IHT liability on such transfers. It is important to understand the available tax reliefs, such as business property relief and agricultural property relief, as these can significantly reduce IHT liability for trusts and assets.
These trusts can incur several tax charges: an entry charge upon creation, a periodic charge every 10 years, and an exit charge for distribution. Gifts to discretionary trusts are considered chargeable gifts (chargeable lifetime transfers) and may be included in the calculation of the settlor’s estate for IHT purposes. If the value of these chargeable gifts exceeds the settlor’s nil rate band, they may be subject to immediate IHT charges.
Discretionary trusts are subject to the IHT relevant property regime, chargeable transfers, and periodic assessments. The maximum IHT rate every 10 years is 6%, and there is no exit charge if the distribution is made within 3 months of the 10th anniversary. Working with professional advisors can help with inheritance tax.
Income Tax
Trustees of discretionary trusts should be aware that the trust’s income is taxed differently from personal income, and they are responsible for managing these distinct tax obligations. Trustees can choose to distribute income to beneficiaries or retain it within the trust, depending on the trust’s objectives and tax planning needs. Income tax on the trust’s income is paid at trust rates. Income distributed to beneficiaries comes with a tax credit, and trustees are responsible for the payment of tax on the total income of a trust. Trusts with total income below £500 will not pay any income tax, but those with income above this threshold will pay significantly higher tax. From 2024-25, the income threshold below which a discretionary trust’s income will be written down to zero for tax purposes is £500.
Income above £500 will be taxed at 45% for all sources or 39.35% for dividends. Trustees do not have dividend and personal savings allowances for the trust income so proper planning and management of the trust’s income is necessary.
Capital Gains Tax
Capital gains tax planning (CGT) is another consideration for discretionary trusts. The annual exemption for CGT for discretionary trusts is currently £1,500. CGT rates for discretionary trusts on property is 20% or 24% for non-residential property (20% or 28% for 2023/24).
Trustees can elect to hold over CGT on transferred assets, delaying the tax until those assets are sold or transferred to a beneficiary. Investment bonds held within a discretionary trust can offer tax advantages for growing the trust’s capital, as gains can be accumulated within the trust rather than distributed immediately. Trustees can choose to accumulate gains within the trust’s capital, which can impact future tax liabilities and enhance the investment potential of the trust. Under certain circumstances, CGT on distributions from discretionary trusts can be deferred and trustees can claim Principal Private Residence (PPR) relief when disposing of residential property.
Who can be a Trustee?
Anyone can be appointed as a trustee of a discretionary trust, but they must be trustworthy and financially astute to manage the trust in accordance with the trust deed. Appointed trustees are responsible for overseeing the trust’s assets and making decisions regarding beneficiaries as outlined in the trust deed. Trustees are also responsible for the ongoing management of the trust, including investment decisions, compliance, record-keeping, and communication with beneficiaries. Trustees have more powers than other trustees to decide on distributions from the trust and can deny benefits to beneficiaries based on their discretion.
To avoid conflict of interest, at least one trustee should be someone who has no interest in the trust. This ensures that trustees act impartially and in the best interest of the beneficiaries and the trust.
Who can be a Beneficiary?
A discretionary trust can have one or more beneficiaries, including individuals, charities, and even future generations. Beneficiaries of a discretionary trust can be anyone, even unborn individuals. They can be specific individuals or classes such as children and grandchildren, giving flexibility in estate planning. Beneficiaries can also be future descendants and vulnerable family members who need financial support. The trust may also name potential beneficiaries—those who may benefit from the trust in the future, but who do not have an automatic right to receive assets. Only when the trustees decide to distribute funds do potential beneficiaries become actual beneficiaries.
Assets in a discretionary trust are outside the beneficiaries’ estates so assets are protected and used as intended.
Creating a Discretionary Trust
To set up a discretionary trust, it can be established during a person’s lifetime or through a Will to take effect after death. The trust is created by a legal document called a trust deed, which sets out the rules of the trust, the roles of the trustees, and the procedures for distributing assets. The settlor will typically draft a letter of wishes to guide the trustees in making decisions. This letter is a critical document which outlines the settlor’s wishes and provides a framework for the trustees to follow, ensuring that the trustees manage and distribute the trust assets in line with the settlor’s preferences.
Trustees hold the legal ownership of the trust assets and are responsible for managing them in accordance with the trust deed. They can decide the amount and timing of distributions to beneficiaries, giving a high degree of flexibility and adaptability. This is particularly useful for estate planning so trustees can respond to changing circumstances and beneficiaries’ needs.
But trusts can be complex for lay trustees to understand the trust and tax laws. Professional advisors offer full service for all aspects of trust administration and estate planning so the trust is managed properly and in compliance with the law. It is strongly recommended to seek professional advice to ensure the trust is set up and managed appropriately for the particular circumstances of the settlor and beneficiaries.
Common Uses for Discretionary Trusts
Discretionary trusts are used to protect assets from being depleted by beneficiaries who may not have financial management skills or be influenced by unsuitable factors such as addictions. These trusts can also safeguard assets from the poor life choices of beneficiaries that could otherwise jeopardize the trust’s assets or viability. Trust help with inheritance is crucial as these trusts manage inheritance tax and facilitate the transfer of wealth and property to beneficiaries, providing tax efficiency and strategic advantages in estate planning. Trustees are responsible for monitoring the trust’s performance to ensure long-term sustainability and benefit to beneficiaries. These trusts protect the assets so they are used in the best interest of the beneficiaries.
They also protect assets from business creditors or during divorce proceedings, so additional protection for the settlor’s wealth. Discretionary trusts are useful for estate planning to preserve the beneficiaries’ inheritance from external threats. Settlor interested trusts can also be part of this process.
Also discretionary trusts can maintain eligibility for government benefits for people with disabilities so support is available without jeopardising the financial assistance. These trusts can have beneficiaries from various classes such as future generations and unborn children so flexible and adaptable estate planning.
How We Can Help
Professional advisors such as ourselves at dns can help you setting up trusts. Financial advisers play a crucial role in managing trusts alongside other professionals such as solicitors and tax specialists. They have the experience and knowledge to make sure the trust is tax efficient and in compliance with the law. Professional trustees can also be appointed to manage the trust impartially and in accordance with legal and fiduciary duties. Advisors work with international and high net worth clients so have solutions for specific needs.
A letter of guidance is often recommended to help the trustees make decisions in line with the settlor’s wishes. Professional advisors help trustees make informed decisions regarding trust management and asset distribution. Keeping good records of trust additions and investments is important for trust management.
Professional financial advisors also help with inheritance tax so ten year charges and exit fees are managed properly. Call us on [03300 575 902](tel:03300 575 902) for Trust Registration Services
Conclusion
Discretionary trusts are a flexible and powerful way to manage and protect assets so beneficiaries get support in line with their changing needs. By giving more power to the trustees these trusts offer a tailored approach to distribution of funds, protection of assets from creditors and other threats.
Whether you want to protect your wealth from legal challenges, provide for vulnerable family members or estate planning, discretionary trusts are a valuable tool. With professional advisors you can navigate the trust administration and tax implications so your trust runs smoothly and efficiently. Read the benefits and drawbacks in this blog and start securing your legacy today with a discretionary trust.
FAQs – Discretionary Trust
What is a discretionary trust?
A discretionary trust gives flexibility by allowing the trustees to decide when and how much to distribute to the beneficiaries. This structure means funds are managed according to the beneficiaries’ needs and circumstances.
Who can be a trustee of a discretionary trust?
A trustee of a discretionary trust can be anyone deemed trustworthy and financially literate. It’s important the appointed person has the necessary skills to manage the trust properly.
What are the tax implications?
Discretionary trusts have tax implications, inheritance tax, income tax and capital gains tax. You need to understand these to comply and plan properly.
Who can be a beneficiary of a discretionary trust?
A discretionary trust can have beneficiaries from various classes, individuals, unborn children and vulnerable family members. This flexibility allows the trustee to distribute benefits according to the needs and circumstances of the beneficiaries.
How can we help?
We can set up and manage discretionary trusts so they comply with the law and are tax efficient. Our expertise prevents problems and makes the trust work for the beneficiaries.
