Discretionary Trusts

FLEXIBILITY & PEACE OF MIND

A Discretionary Trust is often used to protect beneficiaries from various risks, such as poor financial decisions, external influences, and, in certain cases, inheritance tax. This type of trust ensures that beneficiaries do not inherit assets directly from an estate. The assets are safeguarded because the beneficiaries do not legally own the trust fund assets. Trustees will only make distributions if they believe it is advisable and in line with the letter of wishes. This structure helps protect your legacy from third parties and prevents it from being squandered.

There are several reasons for establishing a discretionary trust;

• Safeguard assets from potential divorce,
• Issues related to gambling or substance abuse,
• Unmarried couples tax mitigation.
• Respond to changing circumstances
• Providing for multiple generations
• Protecting the young, vulnerable or disabled
• Inheritance tax planning

Additionally, it allows a testator to specify how and when the assets should be distributed, which may not be possible with a standard Will, particularly at different stages in people's lives.

This type of trust is effective because the Trustees hold and manage the assets to distribute to the beneficiaries at their discretion. Hence the name of the trust. Just because a beneficiary is named under the trust does not mean they are absolutely entitled to any assets – useful where the Trustees may have concerns over how the money may be used.  Where beneficiaries are named under the Trust, this can help to reduce the risk of Inheritance (Provision for Family and Dependants) Act 1975 claims.

It is highly recommended not to appoint only the beneficiaries as Trustees, as this gives them complete control over the Trust. In more complex estates or family situations, it may be beneficial to consider appointing a professional Trustee. Additionally, it is important to choose someone who is empathetic to the beneficiaries' needs but strong-willed enough to avoid being coerced by them. Furthermore, a letter of wishes should accompany the Trust to guide the Trustees in managing it according to the Grantor's intentions.

Why use a discretionary trust?

The reasons to use a discretionary trust usually come down to either:

• Protection: This may be protecting the beneficiaries from themselves, for example, due to addiction concerns, from third parties such as a potential divorce or bankruptcy and Inheritance tax, for example, unmarried couples.
• Flexibility: This could be flexibility for beneficiaries, such as a beneficiary who lacks the financial ability to manage the inheritance themselves, or for flexibility for the testator, for example, if they may want to amend the distribution of the estate often (but the beneficiaries will remain the same).

Protection from Themselves.

Imagine giving hundreds of thousands of pounds to an 18-year-old. Not only could that money be lost or wasted quickly, but it could also potentially cause significant harm to them, physically and emotionally. Spending it on cars, alcohol, faux-friends, parties, unwise investments, or risky business ventures could have negative consequences. The guilt that follows such a spending spree could affect the beneficiary for a lifetime. One of our clients said he inherited £50k from his grandfather in the late 90s. What took his grandfather 80 years to accumulate lasted just over two years, funding the start-up of a boy band. When the money was gone, so were the "friends" and potential deposit for a house.

Protection from Bankruptcy & Insolvency

Even the most prudent individuals can face challenges during tough times, particularly when they take on caregiving responsibilities or experience recent bereavement or divorce. Many successful businesses have failed due to external factors, such as the credit crunch and the COVID-19 pandemic. Additionally, funds held in a discretionary trust cannot be evaluated during bankruptcy or insolvency.

Protection for Vulnerable or Disabled Beneficiaries

There is a dedicated article on this topic, but it is worth noting that there are additional allowances and tax benefits for vulnerable or disabled beneficiaries. Funds in the Trust are not considered in Means tests; therefore, they usually do not result in the loss of other benefits.

Tax Savings for Unmarried Couples.

Unmarried couples do not receive any additional tax allowances. Therefore strategic use of a discretionary trust can mitigate some of the costs.

Can you have a discretionary trust for one person?

It's important to remember that a Discretionary Trust requires a minimum of two beneficiaries to maintain its discretionary nature. Suppose there is only one beneficiary at the time of the benefactor's death. In that case, the assets held in the Trust are considered owned by that beneficiary, effectively making those assets an entitlement for them. This scenario typically arises when all beneficiaries of the Trust are explicitly named.

Trustees should have the discretion to choose which beneficiaries to support. Therefore, a Discretionary Trust needs to include more than one beneficiary or at least have the potential to expand the class of beneficiaries in the future. For example, if a client has one child but specifies the class of beneficiaries as "my descendants," this is acceptable because there may be additional future beneficiaries for the trustees to consider.
If the beneficiaries are described as a class, such as "my descendants," this does not cause the Trust to fail. Even if there is only one remaining beneficiary, it is legally possible for the number of beneficiaries in that class to increase. For instance, that child could have their own children or adopt, allowing the Trust to continue as if there were multiple beneficiaries.

Who is involved?

Settler

The person putting assets into the Trust in their Will.

Testator

The person who the Will is for. The same person as above

Beneficiaries

Individuals, groups of people (e.g., my siblings), or charities are Potential recipients of a trust's assets. The Letter Of Wishes can offer guidance regarding distribution.

Trustees

Trustees decide when to give money or assets to beneficiaries based on the circumstances at the time. They have legal responsibility for the trust. You can appoint family and friends (including beneficiaries), but you must be confident they will act fairly. Between two and four trustees should be appointed. Alternatively, you can appoint professional trustees for neutrality and expertise.

Advisors

Accountants, Financial advisers, or professional trustees can help set up and manage the Trust. The Will Writer may also be known as an Estate Planner and/or a Private Client Consultant.

How long can a discretionary trust last?

Discretionary trusts are usually written to last 125 years; it is not possible for them to last longer. The trust could be ended earlier than this, for example, if all the beneficiaries have died (in which case the trust assets would pass to the default beneficiaries) or by the trustees distributing all the trust assets to the beneficiaries.

What should the letter of wishes be used for?

The trustees of a discretionary trust have complete discretion in using the trust assets. Therefore, the trust itself won’t specify the distribution of the trust assets, such as what percentages the clients would want the beneficiaries to inherit or any other particular wishes they may have any specific wishes on how the trustees should exercise their discretion should instead be kept in a separate letter of wishes to the trustees. This can include wishes such as how much each beneficiary should inherit, at what ages and any concerns the testator may have over how the beneficiaries should inherit. The trustees would consider this letter, but it is non-binding.

Can the Residential Nil Rate Band apply?

The Residential Nil Rate Band (RNRB) cannot apply if it is intended that the deceased’s primary residence forms part of a discretionary trust and is to remain in the trust for the long term. However, if the trustees appoint the home out of the trust to direct descendants within two years of the testator’s death, RNRB will then apply. This is due to rules contained in S144 Inheritance Tax Act 1984, which mean that distributions from the trust within two years of death are treated for IHT purposes as if the will had gifted the assets to the beneficiary.

Are there costs?

Discretionary Trusts have specific rules regarding Income Tax, Capital Gains Tax and IHT.

If the trust still exists two years after death, the trustees must register it with HMRC within 90 days. The exception is that if the trust incurs a UK tax liability earlier than the two-year anniversary, it must be registered within 90 days of the liability arising. Your trustees may need to seek financial, legal, or tax advice to manage the trust correctly and tax-efficiently. These costs are deductible from the trust fund. You may consider such costs to be incidental and outweighed by your reasons for, including trust and the benefits this can bring.

How is a discretionary trust taxed?

Inheritance Tax (IHT)

The starting value is the amount the trust fund received from the deceased estate.

If the starting value is less than the Nil Rate Band (NRB), no exit charges will apply in the first 10 years.

The trust fund will be revalued every ten years, and IHT will be charged up to 6% on the amount exceeding the NRB and reliefs at the time.

When the trustees pay beneficiaries, an exit charge may be applied if the trust's value exceeds the NRB. The amount payable will be calculated based on the length of time held in trust since commencement or of the most recent ten-year anniversary date.

Within the first two years of the deceased's death, the trustees may avoid exit charges by using S.144 of the Inheritance Tax Act. If the trust contains residential property owned by the deceased, the trustees may choose to appoint the property to qualifying beneficiaries for the Residential Nil Rate Band (RNRB) to be claimed.

After this, time trustees may distribute from the trust fund itself without an exit charge within the first quarter of every ten-year interval.

Capital Gains Tax (CGT)

The death of the testator (person making the Will & Trust) does not make a charge to CGT.

The Trustees receive the Trust at Probate value -known as the trustee's base cost.

Charges to CGT arise when property or other assets (provided they are not exempt) are sold or transferred to beneficiaries and when their value increases above the trustee's base cost.

From April 2024 the annual exempt allowance is £1500. If there are multiple trusts, the allowance is shared between them.

The CGT rates for trustees are 20% and 28% for residential property.

Income Tax

The trustees will pay tax on the first £1000 of income tax received annually at the standard rate of 20% and 8.75% on dividends.

After this, trust income is taxed at 45% and 39.35% on dividends.

If the trustees make an income payment, the net amount is passed to the beneficiary. The trustees must keep sufficient funds to pay the tax and issue the beneficiary with an R185 form that can be used in their own self-assessment.

Depending on the beneficiary's income tax rate, they may be able to reclaim some or all of the tax paid by the trustees.

Important Note:

There is always a chance that a court may overturn a trust and make judgments about distribution. This is important in cases involving council applications for care costs, divorce proceedings, and claims for provision for family and dependents.

Tax allowances and legal precedents can change over time, so trusts are drafted based on current knowledge and reasonable predictions. Trusts can be amended at any time before the grantor's death, subject to mental capacity and, in some cases, up to two years after their death. Although it is not advisable to rely on this, it remains an important factor to consider when calculating various future variables.

This is not tax or legal advice and is based on the regimes at the time of writing.

Case Study

Chris set up a discretionary Trust in his Will to benefit his children, Olivia and Jack. The trust fund contains cash and investments. Rachael and Jill (Olivia and Jack's Aunties) are the trustees.

Chris wanted the trust to help his children get the best start in life. Rachael & Jill are happy to make decisions about using the trust fund but prefer to get professional help with managing the trust's tax and legal aspects. Jack has just turned 20, so the fund is used to pay for driving lessons and a car. The trust will also cover his university fees, which trustees pay directly. Olivia, 22, has graduated and is working full-time. The trustees decide to pay off her student debt and help her with a deposit on her first home.

Inheritance Tax

Whether IHT charges apply during the first ten years depends on the starting value and whether it exceeds the NRB, which is currently £325 until 2026.

Example 1: Starting at £300k

• There are no exit charges on distributions from the trust during the first ten years.
• The trust fund will be revalued at the ten-year anniversary, and if below the NRB at the time, no charges will apply. If above the NRB a maximum of 6% on the value above the NRB may apply.

Example 2: Starting at £800k

• As the value exceeds the NRB, the trust may be liable to exit charges on distributions from the trust at a maximum of 6% on assets above the NRB. The actual rate is calculated based on when the distribution from the trust is made.
• The trust fund will be revalued at the tenth anniversary. Whether exit charges continue to apply depends on whether the trust funds remain above the NRB at that time.

Income tax

During the Trust period, Rachael and Jill must submit annual tax returns declaring all the income received by the trusts. The income tax rates for the applicable year will apply.

Rachael and Jill issue a tax certificate at the end of each tax year. Jack is a non-taxpayer, so he claims back all the income tax paid to him by the trust. Olivia is a basic-rate taxpayer, so she reclaims the tax paid at the higher rate.

Capital Gains Tax

If the trustees sell Chris's investments, CGT may be due if the investments have increased in value since his death. The trust allowance is half the personal allowance. The trustees could choose to appoint investments to Jack and Olivia so they can use their own personal allowances and potentially reduce tax liability.

Planning Opportunity

Suppose that by the time Chris dies, Jack and Olivia will be older and have steady jobs. The trustees may decide there is no need for the Trust and want to appoint all the assets equally to Jack and Olivia.

If they do this within two years of Chris's death and comply with legal formalities, for tax purposes, the gifts to Jack and Olivia are treated as though they were made in Chris's Will. Exit fees would not apply, and Jack and Olivia would inherit assets from the trust at the value they held when Chris Died.

Remember

Your trustees may seek financial, legal, or tax advice to manage the trust correctly and tax-efficiently. These costs are deductible from the trust fund. You may consider such costs to be incidental and outweighed by your reasons for including the trust and the benefits this can bring.