When making long-term plans, it can be difficult to predict which of your potential beneficiaries might be in greatest need. A discretionary trust can be made flexible enough to allow your trustees to react to events as they arise.
Discretionary trusts may also allow you to provide for beneficiaries whom you may never meet, such as great-grandchildren or perhaps even more distant descendants. As long as the class of beneficiaries specified in the trust covers them, a discretionary trust could benefit someone born long after the trust was created.
There are some disadvantages to discretionary trusts, however. Due to their more complex nature, the administration costs for the trust may be higher than more straightforward arrangements, although there are ways to mitigate this.
Discretionary trusts also place a lot of power into the hands of your trustees. You must select your trustees very carefully as a result and you may wish to provide them with additional guidance as to how you wish them to administer the trust by creating, for example, a letter of wishes to sit alongside the trust.
As mentioned above, it is entirely possible for a beneficiary to receive nothing from the trust if the trustees decide this is the right way to distribute the income or assets. This may lead to jealousy amongst potential beneficiaries, perhaps causing acrimony and legal disputes.
How are discretionary trusts taxed?
Inheritance tax – The inheritance tax treatment of discretionary trusts is quite complicated. It will depend on a few different circumstances – the first of these is whether the discretionary trust was set up in your lifetime or whether it is to come into being through your Will (referred to as a Will trust).
Lifetime discretionary trusts
In a similar way to a life interest trust, transfers into discretionary trusts during your lifetime can incur immediate inheritance tax charges. Again, this will occur if the value of the trust assets is greater than your inheritance tax ‘nil rate band’, which is currently £325,000. The tax rate for lifetime transfers is lower than the standard rate of inheritance tax upon death, however (20% rather than the 40% rate charged on death).
Once set up, the trust will be subject to inheritance tax under the ‘relevant property regime’ (see the boxout above).
Discretionary Will trusts
If your Will provides for the creation of a discretionary trust, the relevant property regime may not apply. Special provisions mean that a discretionary trust which is completely distributed within 2 years of the date of your death is taxed differently. Instead, in most situations, the trust property will be taken into account in your estate’s inheritance tax calculation, as though the trust assets were still a part of your estate. These provisions can be used to ‘dismantle’ the trust by trustees if this would be advantageous. This also adds a further degree of flexibility to the discretionary trust and can potentially avoid inheritance tax if your estate is able to make use of exemptions or reliefs which would not be open to the trust under the relevant property regime.
Income tax – Any income generated by the trust assets will be payable by the trustees out of the trust funds. If the income is then advanced to one or more of the beneficiaries, it means some income tax will already have been paid on it. The trust’s income tax rate may well differ from that paid by a beneficiary:
- If the beneficiary pays income tax at a higher rate, the tax already paid will be taken into account but the beneficiary will have to pay the difference.
- If the beneficiary would have paid less income tax than that paid by the trustees, the beneficiary can claim a repayment.
Capital gains tax – Any disposals, or deemed disposals, of the assets in the trust may incur charges to capital gains tax. If any such tax is payable, it will be the trustees who are responsible. Actual disposals will include situations where, for example, the trustees sell a property contained within the trust. The proceeds of the sale will still be held on trust but if there has been a gain on the value of that property (compared to its value at the time it was acquired by, or put into, the trust), this would result in a capital gains tax charge.
Deemed disposals include situations where a beneficiary becomes absolutely entitled to any trust assets. Usually this will be when trustees use their discretion to advance trust assets to that beneficiary. For capital gains tax, this is treated as if the beneficiary were buying the asset at the current market value, so a taxable gain for the trust could occur. Again, it would be the trustees who would be responsible for paying this out of the trust funds.
Once the asset is transferred to the beneficiary, if they later go on to sell it, they may face a capital gains tax charge themselves.
Also, you, as the settlor, may incur a capital gains tax charge when transferring an asset into a trust. It is treated as a deemed disposal, with the trustees acquiring the asset at the current market value. So, if this value is higher than that for which you acquired it, this may be a taxable gain.