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Discretionary trusts: pros and cons

3 Mar 2023

If you’re looking to pass on wealth to a family member, say a child or grandchild, setting up a trust fund could be an attractive option.

A trust is a legal arrangement that involves a settlor, who puts assets into a trust fund, which is then managed by trustees for the benefit of a beneficiary or beneficiaries. Different kinds of assets can be put in a trust, including cash, property, shares, unit trusts and land.

A recent internal event, during which Courtiers colleagues shared knowledge across various departments, highlighted a couple of the more common trusts that Courtiers clients use. The first of these is what are called discretionary trusts. So, what is a discretionary trust, when might it be useful? And are there any drawbacks?

Flexibility

Of all the various types of trust, discretionary trusts are probably the most flexible. As the name suggests, trustees have complete discretion over who the beneficiaries are and the assets they receive and when. This contrasts with bare trusts, where as soon as they reach the age of 18, a named beneficiary has the absolute right to the trust’s assets and when they receive them. The flexibility of discretionary trusts means they can be adapted to changing circumstances, even when the settlor has passed, such as a beneficiary falling on hard times.

Discretionary trusts can last up to 125 years. A discretionary trust can be created when the settlor is alive, or in their will.

Many uses

Like all types of trust, discretionary trusts are a good way to provide for loved ones. But they are particularly suited for when you don’t want people to receive the assets right away. Especially where a large sum of money is involved, you might prefer that the trustees of the trust fund manage the assets instead. Examples could include where those you wish to provide for are children, people with learning difficulties, or people who might squander the money in an irresponsible way.

A discretionary trust can also be a very useful way to protect assets from third parties, such as future divorced spouses and in the case of bankruptcy from creditors. Beneficiaries don’t have any legal entitlement to assets in a discretionary trust and consequently they don’t form part of their estate on divorce, bankruptcy or death. These details are set out in a document called a trust deed.

Trustees have the final say

A discretionary trust is most useful when the person who puts the assets into trust (the settlor) doesn’t require certainty over who the beneficiaries are. Instead, they can name potential beneficiaries, but leave the ultimate decision up to trustees. Although a potential beneficiary can be a named person, it can also include classes of potential beneficiaries, including children, grandchildren, and other family members. Even people not yet born, such as future grandchildren can be beneficiaries.

Expression of wishes

Discretionary trusts are often used in conjunction with an expression of wishes. Although not legally binding, this gives trustees guidance on how the settlor would like the trust to be administered. We covered this subject last year. The expression of wishes could stipulate, for example, that the beneficiaries should receive only income and not capital, or that assets should be distributed on a beneficiary’s 21st birthday.

Taxes

During the life cycle of a discretionary trust the trustees, the settlor’s estate, settlor and sometimes the beneficiary may be liable for various tax charges. The information below relates to UK-resident trusts. These are defined as trusts, where either all the trustees are resident in the UK, or where at the time the trust was created or assets added, there was a mixture of resident and non-resident trustees and the settlor was resident or domiciled in the UK. The tax rules on non-resident trusts are very complicated and beyond the scope of this article. For further information, please contact your Financial Adviser.

Entry charges

For lump-sum investments, the initial gift into a trust is a chargeable lifetime transfer for Inheritance Tax (IHT) purposes. This means there could be tax to pay if the gift is over the Nil Rate Band (NRB). The current NRB is £325,000. Anything over this is liable to an immediate 20% charge on the trustees. This applies even when the settlor is living. The gift is calculated by adding up the value of any transfers and any chargeable gifts made in the previous seven years by the settlor. If the settlor pays the IHT, the amount of tax due increases. If a couple is creating a trust, they can double the NRB to £650,000.

If the value of the assets transferred to the trust has risen since the settlor acquired it, the settlor may be liable for Capital Gains Tax (CGT).

On the death of the settlor

If the settlor dies within seven years of making a transfer into a trust, their estate will have to pay IHT on the full value at 40%. In such a scenario, the person managing the estate will have to pay a further 20%. This is based on the value of the original transfer.

Taxation of trustees

The trustees of a discretionary trust fund may also be liable for tax.

Periodic charges

The trust will be subject to periodic IHT charges applied on every 10th anniversary of the trust’s creation. The charge will be payable on the value of the trust’s assets above the Nil Rate Band. This won’t apply if the assets have passed to the beneficiary before the 10-year anniversary. This charge will apply even while the settlor is still alive.

Exit charges

An IHT exit charge up to a maximum of 6% is payable when ‘relevant property’ – assets such as money, shares, houses or land are transferred out of a trust and distributed to a beneficiary. There is no exit charge if the trust fund is distributed within two years of death. Inheritance Tax may also be due when the trust ends.

Income Tax

Trustees are also responsible for paying tax on income received by discretionary trusts.

For trust income up to £1,000, the tax rate is 8.75%, for dividend income and 20% for all other income.

Above £1,000 the rates are 39.35% and 45% respectively. Trustees do not qualify for the dividend allowance so pay tax on all dividends the trust receives.

If trustees distribute income to a beneficiary, depending on the type of discretionary trust and the beneficiary’s tax rate, the beneficiary may be able to claim tax back on trust income they’ve received.

However, in cases where a settlor is also a beneficiary, the beneficiary may be taxed on any income arising to the trustees.

Capital Gains Tax

Trustees may be liable for CGT, currently 20% (28% on residential property) in respect of any gains above the trust’s annual exemption amount, currently £6,150 in most cases. The latter figure is due to fall to £3,000 from the start of the 2023/24 tax year in April. One point to note is that if gains are eligible for tax relief, trustees may be able to reduce or delay the amount of tax due.

Different rules

Different rules apply where a trust is a discretionary loan trust or a discounted gift plan, or where a life insurance policy is held in a discretionary trust. These rules are complex, so it is always best to speak to a Financial Adviser.

Some drawbacks

  • Beneficiaries left out may feel aggrieved.
  • Loss of control. The trustees can ignore the settlor’s wishes.
  • Trusts can be costly to set up and run.
  • As with all trusts a discretionary trust needs to be properly administered. This includes registering it with HMRC’s online Trust Registration Service, filing annual tax returns and issuing tax certificates to beneficiaries who have received income.

Conclusion

Discretionary trusts are particularly suitable for people who are happy to leave decisions about the management and distribution of the fund’s assets to trustees. They can also be very useful for estate planning. Although a discretionary trust can be used to mitigate IHT, the potential for the settlor’s estate and trustees to be taxed in various ways should not be overlooked. Trustees have the ultimate say in how a discretionary trust is administered, highlighting the importance of choosing trustees wisely. Because of the complexity of trusts, it’s always advisable to seek expert professional advice before setting up a trust. You will also need to appoint a solicitor.

Important information

The views expressed by Courtiers in this summary are reached from our own research. Courtiers cannot accept responsibility for any decisions taken as a result of reading this article. Investors are recommended to take independent professional advice before effecting transactions and the prices of stocks, shares and funds, and the income from them can fall. Past performance is not a guide to future returns. Tax treatment depends on individual circumstances and may be subject to change in future. We do not endorse or accept responsibility for website content on any websites other than those operated by Courtiers, which may be accessible via links in this article.

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