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Discretionary or Flexible Trust

In a discretionary trust, the trustees have discretion about the distribution of trust assets, subject to the terms in which that discretion is granted. For example, about which beneficiaries to pass it on to, how much each will get, and when they will get it.

Discretionary trusts are commonly used to keep wealth within families while allowing them flexibility to make decisions about where the assets go.

Discretionary trusts are the most flexible form of trusts used to provide for families and other loved ones.

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Discretionary trusts are typically used where the settlor wants the trustees to have maximum control over who shall benefit and exactly when. No beneficiaries will have an automatic entitlement to the income, capital or trust. In which case, the trustees decide how often payments are made, who they are made to (which beneficiary) and how much is given.

If they choose not to distribute the accumulated income, the trustees can hold it in the trust. The accumulation period for income on older trusts may be limited.

A discretionary trust may have named beneficiaries but will frequently contain classes of potential beneficiaries such as children, grandchildren and/or other family members. To ensure that the discretionary powers are according to what they wish for, the settlor will normally also be a trustee.

Key features of a discretionary trust:

  • The payment of capital and income are managed by the trustees.
  • An immediate charge of 20% can be attracted on lifetime gifts to discretionary trusts.
  • Discretionary trusts might be subject to an IHT charge of up to 6% every 10 years, and when the capital is paid out.
  • Those who do not pay tax at the top rate can reclaim the tax credit of 45% that comes with the income paid to a beneficiary.
  • Tax can be deferred using holdover relief. However, the transfer of assets into and out of trust will be a disposal for CGT.
  • The trust rate for capital gains is 20% (28% for gains on residential property)
  • Almost half of the individual amount might have an annual CGT exemption. 

None of the beneficiary have an automatic entitlement to the trust income or capital. The trustees have the discretionary power to decide whether to pay out income or add it to the trust capital. When capital payments are made to beneficiaries is also decided by them. 

Normally the settlor and their spouse are excluded under the terms of the trust to avoid the trust income being taxed on the settlor. This creates flexibility when it comes to settling funds on trust for IHT planning purposes.

Discretionary trusts are popular in IHT planning as the lifetime nil rate band, currently £325,000, can be settled on trust without a lifetime IHT charge.

Also, assets that qualify for 100% business or agricultural property relief can be settled on trust in most situations without a lifetime IHT charge.

Provided the settlor has not retained an interest under the terms of the trust, the property settled will not be treated as being included in his estate.

Because discretionary trusts offer so much flexibility, they continue to be a useful tool in estate planning.

The trustees have complete discretion over the payment of both capital and income. This allows the trustees to pay out at the appropriate time if funds are needed for a particular purpose. Alternatively, where minors are the beneficiaries they can wait until they feel that the beneficiaries are old enough to look after the money themselves

Once the children are older, trust income can be distributed to them or used for their benefit, for example to pay for their education.

Care must be taken when parents set up trusts for minor children however, as in many cases the income will become taxable on the parents.


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The Pros

> Gives trustees total discretion over the distribution of income and capital
> Total flexibility on when to pay out, to whom to make the payments, how often to make payments and if they would like to impose any conditions on the recipients

The Cons

> Subject to periodic ten-year annivesary charge & exit charges
> Gifts into the trust will be chargeable lifetime transfers (CLT)
> Does not allow the settlor any access to any of the trust funds
> Intial IHT charge of 20% on setup of a CLT over the available Nil Rate Band
Who are the trustees?

Who exactly the trustees are will be outlined in the trust deed and can be either professionals or non professionals appointed by the settlor.

The difference is that professional trustees can charge fees for their services.

What are the reasons for using discretionary trusts?
  • Discretionary trusts may be created during lifetime or on death. They are typically used where the settlor wishes the trustees to have maximum control over who will benefit and when. The settlor may provide the trustees with an expression of wishes that can guide them in how to exercise their discretionary powers. It is important to note that this would not be a legally binding document but can provide clear guidance to the trustees.
  • This level of control and flexibility comes at a price of a heavy tax regime than some other types of trusts. Discretionary trusts are subject to the IHT relevant property regime. Gifts into them are chargeable transfers and the trust may be subject to periodic and exit charges. Trust income and gains are subject to the trust rates of tax.
  • Married couples use Discretionary will trusts to take advantage of the nil rate bands. On first death, an amount up to the nil rate band was put in trust for which the survivor was also deemed a beneficiary; the balance of the estate then passes IHT free to the beneficiary that is alive. 
  • Reasons for using a Discretionary will could also include: control, flexibility and asset protection.
Do will additions apply to the assets in trust?

If property is added to a trust between 10 year anniversaries, these will already be included in the value on the periodic charge date.

But because these assets have not been relevant property for the full 10 year period, the ‘actual rate’ applying to those assets will need to be adjusted.

The adjustment made is to multiply the actual rate by (40 - X) where X is the number of complete three month periods between the creation (or last 10 year anniversary) and the date of the addition.

It's therefore important for trustees to keep good records of when additions are made and how they're invested.   

Where regular payments have been made using the normal expenditure out of income exemption, these addition rules will apply to the assets in trust.

While the expenditure out of income exemption can reduce IHT for the settlor, it is irrelevant for the calculation of 10 year IHT charges which should be based on the value of the assets to the trustees. 

What is the income tax rate and can it be reclaimed?

The income tax rate is taken in two ways:

  • The 1st £1,000 of the trust income is taxed at the standard rate.
  • Anything over this is taxed at the trust rate.
  • The trust rate is equal to the additional rate for individuals.

Any income that is distributed to a beneficiary will be paid net with a certificate (R185) showing the tax accounted for by the trustees at 45% (the tax credit).

The beneficiary will be liable to tax at their own marginal rate on the gross distribution, but if this is more than the tax credit, some or all of the tax credit can be reclaimed.

Will gifts into the trust be subject to CGT?

Lifetime gifts of existing assets into trust, other than gifts of cash or the assignment of investment bonds, will be disposals for CGT.

Any gains will be assessed on the settlor unless they elect to ‘holdover’ the gain. This election effectively postpones the taxation of the gain until the trustees sell the assets or transfer them to a beneficiary. Holdover is available because the transfer to trust is also a chargeable transfer for IHT.

Holdover relief is not available where the settlor, their spouse/civil partner or their minor (under18) unmarried child can benefit from the trust (these are known as 'settlor interested' trusts).

Assets transferred to trust on the settlor’s death won't normally have been subject to CGT. The trustees will have acquired the assets at their market value at the date of death.

Are there any administration issues with the discretionary trust?

The trustees are the legal owners of any trust assets and investments. All the powers a trustee has must be used in the best interests of the beneficiaries.

Discretionary trusts will need to be entered on the HMRC trust register if they have income or capital gains.

A trust tax return needs to be completed by the trustees every year that there is trust income or gains. Investment bonds may therefore appeal as a trust investment because they are non-income producing and can simplify tax reporting requirements.

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Expert assessment of a discretionary or flexible trust

A discretionary or flexible trust can be a useful solution, but whether it is applicable has to be determined on a case-by-case basis, as does the case for using trusts in general.

If you already have a trust structure in place and would like a Second Opinion - or, if you are wondering whether the utilisation of a trust could be of benefit to you, contact us.

NOTE: Because trusts are so unique to each individual, it’s impossible to give them a rating for their overall performance and suitability. Therefore these reviews do not come with a star rating.


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