What are Discretionary Trusts?

Discretionary trusts, commonly referred to by some as ‘trust funds’, have often been used in the past as a way for wealthier families to keep money, investments and assets within the family for future generations.

But the flexible nature of such trusts means that, far from being a vehicle solely for the rich and famous, discretionary trusts can provide an effective option for anyone looking to provide future support for children or other beneficiaries, as and when it’s most appropriate.

The structure of a discretionary trust enables you, as the person putting your assets or money into the trust (known as the settlor), to give those assets to a group of people chosen by you (the trustees) to look after.

The trust deed will also name the group of people who you want to eventually benefit from those assets (the beneficiaries). Although it will be at the discretion of the trustees to decide which of the beneficiaries to pass assets on to, when, and how much each will receive, you can indicate to the trustees how you would like them to exercise their discretion. So while your wishes are not legally binding on them, they will often take them into consideration.

The assets are ‘held in trust’ for the beneficiaries and, along with any payments received from them, make up the trust fund. The assets no longer belong to the settlor, nor do they automatically belong to the beneficiaries.

Solution to a range of situations

Discretionary trusts can be used to make gifts either during your lifetime or after your death. As well as being flexible, they have proved a popular method of estate planning because assets remain outside the beneficiaries’ estates for Inheritance Tax purposes, and are not included in any calculation for means-tested benefits.

Also, while providing your children and grandchildren with continuing financial support after your death is probably the most common reason for setting up a discretionary trust, there are other circumstances which may prompt a settlor to opt for this more flexible option.

Control

You may wish to gift cash, property or any other asset to your beneficiaries. If, however, you would like to keep control of how the asset is used, then you would be able to do so by remaining one of the trustees. Whilst extracting the asset from your estate and allowing your beneficiaries to enjoy it, jointly with the other trustees you still retain decision making power until transferred to the beneficiaries absolutely.

Divorce asset protection

If a beneficiary is going through a divorce, an appropriate discretionary trust can ensure that assets from your estate won’t pass to their former spouse.

Vulnerable beneficiaries

If a beneficiary has a disability or is vulnerable in some way, or receives other state benefits, then any money paid directly from your estate may merely reduce their entitlement to state support, rather than being of any benefit to them personally. A trust for a vulnerable person can benefit from favourable tax treatment.

Bankruptcy

Similarly to the divorce settlement, if a beneficiary is bankrupt, or in danger of becoming bankrupt, there is a real risk that with no discretionary trust in place, any gift from your estate could be paid directly to the beneficiary’s creditors. So there are a range of situations where a discretionary trust could provide an ideal solution, but it’s important to recognise the tax burdens associated with discretionary trusts, and also to consider whether other planning options would be more tax effective.

A trust is a separate legal entity and transfer of assets into the trust may come with a tax cost.

Tax implications

A discretionary trust will always pay income tax at the highest rate.  For example, any gross income above £1,000 (the standard rate tax band for trusts) is taxable at the current trust tax rate of 45%; the exception to this is dividends, which currently incur a tax rate of 39.35%. When trustees pay income to a beneficiary who is taxed at less than 45%, the beneficiary can reclaim tax so that their eventual tax burden is no greater than it would have been if the trust assets were their own.

There will also be Capital Gains Tax to pay at a rate of 20% (or 24% for UK residential property) if the trust’s annual total taxable gain is greater than its tax-free allowance (currently £1500, or £3000 if the beneficiary is vulnerable).

As well as a 10-year charge (currently up to 6%, payable on the amount by which the value of the trust fund exceeds the nil rate band) and exit costs, there may also be Inheritance Tax (IHT) implications if the value of the assets put into trust by the settlor exceeds the £325,000 IHT nil rate band.

So, while you don’t have to be wealthy to find that a discretionary trust can offer a flexible, effective way of passing assets onto your chosen beneficiaries – both during your lifetime, and following your death – there may be other options, including alternative trusts, which could be more appropriate for your individual situation.

The key issues is to seek expert advice as early as possible, and make sure that any changes in your own personal situation – or your wishes about how you continue to support loved ones – are reflected in your long-term tax and estate planning.