As the name suggests, a discretionary trust generally gives the trustees total discretion over the distribution of income and capital.
The settlor provides the trustees with the names or classes of person who could potentially benefit under the trust, but, the final decision as to the level and frequency of payments is left to the trustees.
This means that until a distribution or appointment is made under the terms of the trust no beneficiary has the right to income or capital, and income which is not distributed is accumulated.
The basics of a Discretionary Trust
The key advantage of the fully discretionary trust is its total flexibility. Essentially the discretion of the trustees over trust capital can extend over the whole term of the trust, i.e. currently in England, 125 years.
Trustees of trusts created on or after 6 April 2010 will also normally be able to accumulate trust income throughout the trust period.
Although the class of discretionary beneficiaries will usually be pre-defined, the settlor or the trustees would normally be given power to add to the class and even remove a discretionary beneficiary. In many cases there will be express provision that the settlor or settlor’s spouse cannot be added as a beneficiary.
The settlor may wish to give guidance to the trustees as to the exercise of their discretion over income and capital and this can normally be done by a letter of wishes, although such a letter will not be binding on the trustees.
The use of Discretionary Trusts in Wills
Nil rate band discretionary trusts were useful where, in the case of a married couple, it was desired to take advantage of the nil rate band for Inheritance Tax whilst ensuring that the surviving spouse could be one of the beneficiaries under the trust. Nil rate band planning in this way is of lesser importance since the introduction of the transferable nil rate band from 9 October 2007 though there are still some situations where it remains useful.
Discretionary trusts in Wills qualify for a particular Inheritance Tax relief. Basically it is possible for an individual to leave all of his estate subject to a discretionary trust and, provided the distribution out of the trust is made within two years of death (but not within the first three months after death), no Inheritance Tax will be charged on the distribution. The distribution by the trustees will be treated as if the Will of the testator provided for it.
The tax treatment of a Discretionary Trust
Inheritance Tax charges may arise on the trust being created, on capital being appointed out of the trust and also on each 10th anniversary of the creation of the trust.
Income inside a discretionary trust is taxed on the trustees at a special rate of 45% on income in excess the standard rate band (normally £1,000 but reduced if the settlor has created more than one trust).
Capital gains realised by trustees of a discretionary trust are taxed on the trustees at 20% unless the asset is a residential property not occupied as a principal residence when the rate is 28%, subject to the trustee annual exemption.
Links to more information
- Inheritance Tax
- Money Advice Service notes on Setting up a Trust
- If you need personal financial advice on a Discretionary Trust then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.