What is a Discretionary Trust?

A discretionary trust is a flexible and powerful estate planning tool used to manage and distribute assets for the benefit of specific individuals, known as beneficiaries. In a discretionary trust, the trustees have control over how and when the trust’s assets are distributed to the beneficiaries. This type of trust is commonly used in the UK to provide financial support while maintaining control over the assets and protecting them from various risks.

In this blog, we’ll explain how discretionary trusts work, when they are commonly used, and the advantages they offer in estate planning.

How Does a Discretionary Trust Work?

In a discretionary trust, the settlor (the person who sets up the trust) transfers assets to the trustees. The trustees manage the trust and decide how the assets are used for the benefit of the beneficiaries. Unlike a bare trust, where the beneficiaries have an automatic right to the assets, beneficiaries of a discretionary trust only receive assets at the trustees’ discretion.

Key parties involved in a discretionary trust include:

• The Settlor: The person who creates the trust and places assets into it.

• The Trustees: Individuals or a corporate entity responsible for managing the trust and making decisions on how to distribute the assets.

• The Beneficiaries: Those who may benefit from the trust. The trust usually specifies a group of potential beneficiaries, but it’s up to the trustees to decide who receives the assets and when.

Trustees may be given the power to decide:

• Who receives income or capital from the trust.
• How much is distributed to each beneficiary.
• When distributions are made.

This flexibility makes discretionary trusts ideal in situations where the settlor wants to retain some control over how the assets are used.

When is a Discretionary Trust Used?

Discretionary trusts are commonly used in several scenarios, particularly when there’s a need to protect assets, maintain flexibility, or provide ongoing support for beneficiaries. Some common uses include:

1. Protecting Vulnerable Beneficiaries

If a beneficiary is not in a position to manage their finances due to age, disability, or other circumstances, a discretionary trust ensures that their needs are met without giving them full control over the assets. The trustees can decide how much and when the beneficiary receives funds, ensuring their best interests are protected.

2. Providing for Future Generations

A discretionary trust is often used by parents or grandparents who wish to leave assets for their children or grandchildren but want to ensure that the funds are used wisely. The trustees can manage the trust until the beneficiaries are old enough to handle their own finances responsibly.

3. Protecting Assets from Creditors or Divorce

Assets held in a discretionary trust are not owned outright by the beneficiaries, which means they are protected from claims by creditors or in the event of divorce. This makes discretionary trusts a useful tool for safeguarding family wealth.

4. Reducing Inheritance Tax (IHT) Liability

By placing assets in a discretionary trust, they are removed from the settlor’s estate, potentially reducing the inheritance tax liability. However, this is subject to certain conditions, such as the seven-year rule, which requires the settlor to survive for seven years after making the gift to avoid the trust being subject to IHT.

Tax Implications of a Discretionary Trust

While discretionary trusts offer flexibility and protection, they also come with specific tax considerations that must be managed carefully:

• Inheritance Tax (IHT): When assets are placed into a discretionary trust, they may be subject to an immediate charge to inheritance tax if the value exceeds the Nil Rate Band (currently £325,000). If the trust exceeds this threshold, a 20% IHT charge may apply when the trust is created. Additionally, there are potential 10-yearly IHT charges (up to 6%) and exit charges if assets are distributed from the trust.

• Income Tax: The trustees are responsible for paying income tax on any income generated by the trust's assets. This is usually taxed at the trust rate of 45%, though beneficiaries may be able to reclaim some of the tax if they are in a lower tax bracket.

• Capital Gains Tax (CGT): If the trust sells or transfers assets that have increased in value, capital gains tax may be payable. Trustees are entitled to a CGT annual exemption, which is half of the individual exemption (£6,000 for 2024-25). Gains above this limit are taxed at 20% for most assets or 28% for residential property.

It’s important to work with a solicitor or tax adviser to ensure that the trust is managed in a tax-efficient manner.

Advantages of a Discretionary Trust

A discretionary trust offers several benefits for those looking to protect their assets and maintain control over how they are used:

1. Flexibility

Trustees have the freedom to distribute income or capital as they see fit, based on the needs and circumstances of the beneficiaries. This is especially useful in situations where beneficiaries have changing needs over time.

2. Asset Protection

Because beneficiaries do not have an automatic right to the trust’s assets, they are protected from creditors, divorce settlements, and poor financial decisions. The assets remain under the control of the trustees, ensuring they are used responsibly.

3. Control for the Settlor

While the settlor cannot directly control the trust after it’s created, they can provide guidance to the trustees through a letter of wishes. This informal document outlines the settlor’s preferences for how the trust should be managed, helping trustees make decisions in line with the settlor’s intentions.

4. Inheritance Tax Planning

Discretionary trusts can be a valuable tool for reducing inheritance tax. By transferring assets into a trust, they are removed from the settlor’s estate, which can help minimise the IHT liability. However, careful planning is required to avoid tax charges on the trust itself.

Disadvantages of a Discretionary Trust

While there are many advantages to a discretionary trust, there are also some potential drawbacks to consider:

• Tax Complexity: Discretionary trusts are subject to a variety of taxes, including income tax, capital gains tax, and inheritance tax. The ongoing tax obligations can be complex, and professional advice is often necessary to ensure compliance.

• Loss of Control: Once assets are placed in a trust, the settlor loses direct control over them. The trustees are responsible for managing the assets, and while they may follow the settlor’s wishes, they are not legally bound to do so.

• Trustee Responsibilities: Trustees have significant responsibilities, including managing the assets, making decisions on distributions, and ensuring that the trust complies with tax laws. It’s important to choose trustees who are capable and trustworthy.

Is a Discretionary Trust Right for You?

A discretionary trust can be a valuable tool in estate planning, offering flexibility, asset protection, and tax benefits. However, it’s not the right solution for everyone. If you have complex family or financial circumstances, or if you want to maintain flexibility in how your assets are distributed, a discretionary trust may be the ideal option.

Before setting up a discretionary trust, it’s essential to consult with an experienced solicitor who can guide you through the process and ensure that the trust is structured in a way that meets your needs and goals.

Conclusion

A discretionary trust is a flexible and powerful estate planning tool that allows trustees to manage and distribute assets in a way that best meets the needs of beneficiaries. Whether you're looking to protect vulnerable individuals, safeguard family wealth, or reduce inheritance tax, a discretionary trust can provide the control and flexibility you need.

If you’re considering setting up a discretionary trust or want to know how it fits into your estate planning strategy, contact the team of estate planners today for personalised advice.