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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.
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:
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.
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.
The income tax rate is taken in two ways:
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.
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.
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.
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.
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.