Discretionary Trusts

Introduction

This briefing sets out what a discretionary trust is, why they are used and the different taxes that apply to them.

Core considerations

Discretionary trusts are where the trustees decide which beneficiary gets the income and the capital from the discretionary class.
The trustees can accumulate income within the trust.
All income and gains are taxed on the trustees at the trustee rate of tax.
Discretionary trusts are taxed under the ‘relevant property regime’.
This means Discretionary trusts may be subject to IHT entry charges when they are set up, periodic charges at each 10 year anniversary and exit charges when monies leave the trust.

What is a discretionary trust?
Why use a discretionary trust?
Income Tax
Capital Gains Tax
Inheritance Tax

What is a discretionary trust?

Discretionary trusts, also known as a ‘relevant property trust’, are typically used where the settlor wishes the trustees to have maximum control over who will benefit and when. The class of beneficiaries is generally quite wide and can include the settlor’s children, grandchildren, and future generations.

The trustees can accumulate income within the trust, and they have the discretion to decide who income and capital is paid to, and when it is paid.

The settlor will normally provide the trustees with a letter of wishes giving them guidance as to the purpose of the trust. The letter of wishes is not legally binding however the trustees can consider the wishes of the settlor when exercising their discretion.

Beneficiaries don’t have an absolute entitlement to the trust fund and therefore it does not form part of any beneficiary’s estate if they divorce, become bankrupt or when they die.

Why use a discretionary trust?

This type of trust generally provides the most flexibility. The trustees have full control of who becomes entitled and when. They are also used for intergenerational planning to ensure wealth passes down the generations due to the wide beneficiary classes.

Typically, they are used for IHT planning as the chargeable lifetime transfer (CLT) generally drops out of the IHT cumulation after 7 years.

Where an individual receives compensation in respect of an injury where this is placed into trust it does not count towards the means test for state benefits. These are often called personal injury trusts and can be set up as discretionary trusts.

For example

Diana and Richard have 3 children with several grandchildren. They want to put money aside for all of them and for any future grandchildren and great grandchildren. They set up a discretionary trust which includes them as a class of discretionary beneficiaries. The class will also include those grandchildren and great grandchildren who were not born when the trust was created.

Diana and Richard have provided the trustees with a letter of wishes stating that they would like the monies to be used to help any of the beneficiaries with the cost of further education and/or getting on the property ladder.

Income Tax

Most trusts do not pay income tax on income up to a tax-free amount of £500. If the settlor has more than one discretionary trust, the £500 is divided by the number of trusts they have. If the trust has total income over the tax-free amount it will be taxed at 45%. Dividends will be taxed at 39.35%.

When trustees distribute income to a trust beneficiary it is paid out of the trust net of the trustee rate of tax and therefore with a tax credit of 45%. A non-tax-payer will be able to claim back the 45%, a basic rate tax payer 25% and a higher rate tax payer 5%.

The trustees must keep accounts and maintain a “tax pool” to record the tax paid within the trust on the income received. Where the tax within the pool does not cover the 45% tax credit the trustees will have to make up the difference out of other trust income or reduce the amount of income distributed to the beneficiary.

For example

Diana and Richard set up a discretionary trust to help their grandchildren with the cost of going to university. They have invested some of the trust funds in unit trusts which distribute dividend income.

They have decided to give their granddaughter Abbey monthly income from the trust to help with the cost of accommodation. The basic rate band for the trust is being used up by other investments therefore all the dividends received are taxable at 39.35%.

This means that the £10,000 dividend income is subject to £3,935 which is recorded in the tax pool. If the trustees paid out the balance to Abbey of £6,065 with a tax credit of 45%, there would not be enough in the tax pool to cover the tax credit of £4,500.

The trustees decide to limit the income paid to Abbey to £5,500 with a tax credit of £4,500 which she will be able to reclaim as she is a non-tax payer. However, as the monies paid to her are deemed as income from the trust, she will not be able to use her dividend nil rate.

Capital Gains Tax

Where assets are transferred directly into the Discretionary Trust the settlor is making a disposal and will therefore be taxed on any gains.

The settlor may make a claim for hold over relief which postpones the gain until they sell the asset or transfer the asset to a beneficiary. Holdover relief is not available where the settlor, their spouse/civil partner or their minor (under18) unmarried child can benefit from the trust (these are known as 'settlor interested' trusts).

If the transfer of assets is made following the death of the settlor there will be no gain realised. The trustees will have acquired the assets at the market value at the date of death.

All gains arising within the trust will be assessed on the trustees. Trustees have an annual exempt allowance, currently £1,500 (tax year 2024/2025) and is half of the individual allowance. This is split between the number of trusts the settlor created during his lifetime up to a maximum of 5 trusts.

Gains within this allowance are not subject to tax, however gains above this allowance will pay the trustee rate for CGT.

The trustee rate from 6 April 2024 to 29 October 2024 is 20% on chargeable assets and 24% for disposals of residential property. The tax rate from 30 October 2024 onwards is 24% on gains from chargeable assets and residential property.

However, trustees can also claim principal private residence (PPR) relief on the disposal of residential property that has been occupied by a beneficiary of the trust as their main residence.

If the trustees transfer an asset to a beneficiary this will trigger a disposal, however, they can elect with the beneficiary to hold over the gain so that when the beneficiary disposes of the asset the gain arises.

For example

Diana and Richard decide to transfer some of the unit trusts directly to Abbey. They elect to hold over the gain which means that when Abbey eventually decides to dispose of the unit trusts any gains will be taxed on her.

Abbey has a full annual exempt allowance to use against any gain with the balance above being taxed at either 10% if she is a basic rate taxpayer or 20% if she is a higher rate taxpayer.

Inheritance Tax

A gift into a Discretionary trust is a CLT. If the settlor exceeds the value of the nil rate band, currently £325,000, in a 7-year rolling period there will be a charge when the trust is created. This charge is called the “entry” charge and is based on half of the death rates and is chargeable at 20% on the value over the £325,000.

It is only CLTs that are included in the cumulation for the calculation of the entry charge. PETs are ignored. Where there are joint settlors the gift is deemed to be made half each unless there is evidence to show otherwise.

Sometimes the settlor may want to pay this charge on top of the transfer into trust in order not to reduce the funds for the beneficiaries. Where the settlor pays this charge it is classed as another CLT and is grossed up giving an effective rate of 25%.

If the settlor dies within 7 years of making the CLT the gift becomes chargeable and uses up some or all the settlor’s available nil rate band. Where the gift exceeds the nil rate band an additional charge of 20% applies. You cannot set CLTs against the residence nil rate band, only the normal nil rate band.

Where tax is payable taper relief may apply depending on the timing between the date of the gift and the date of death.

On each 10th anniversary of the creation of the trust, it may be subject to a charge which is called the “periodic” or “principal” charge. The basis of the charge is based on the value of the trust fund which exceeds the available the nil rate band for the trust and will be taxed at no more than 6%.

There may also be exit charges applied when distributions are made to beneficiaries. These are called “exit” or “proportionate” charges. If there are no entry charges when the trust is initially set up generally there will be no exit charges within the first 10 years. If there are no periodic charges at the 10-year point there will generally be no exit charges for the following 10 years.

Calculating periodic and exit charges can be very complex and are normally carried out by accountants.

For example

Diana and Richard set up a new discretionary trust for £200,000 for the benefit of their children. Last year they set up their first discretionary trust for £150,000 which was for their grandchildren to help them with the cost of going to university.

When they set up their new trust they have to check back 7 years and add together all of the transfers they have made into discretionary trusts, ignoring any PETs. This means that in total they have paid £350,000 into discretionary trusts. Both trusts were set up as joint settlors. If they do not jointly exceed £650,000 there will be no entry charge to pay. If there is no entry charge on the set up of the trust, there will be no exit charges within the first 10 years.

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