Home Personal Inheritance Tax & Family Trusts How Does a Discretionary Trust Work?

How Does a Discretionary Trust Work?

A discretionary trust is one of many different types of trust that are available. The suitability of each type of trust should be determined by a number of factors driven primarily by your personal objectives and plans.

With its high degree of flexibility and wide practical application, the discretionary trust has become one of the more popular types of trust arrangement.

How do trusts work?

A trust is a legal arrangement, in lifetime or on death, in which one party (the settlor) gives a second party (the trustee) the ability to hold assets or property for a third party (the beneficiary). In this way the trust permits the separation of legal ownership and beneficial interest.

Once the trust is established, the settlor gives up legal title to the trust property to the trustees. The trustees are then bound to manage and administer the trust solely for the benefit of the beneficiaries.

A settlor can set up a trust during their lifetime. This is known as an inter vivos trust. Alternatively, a trust can be set up in the settlor’s will, to take effect on their death. In either case, the trust deed will set out how the trust is to operate, including what benefits can be received, by whom and when.

What is a discretionary trust?

The discretionary trust is so called because no beneficiary has a fixed or absolute entitlement to any share in it. Under a discretionary trust the trustees have the discretion, within the rules of the trust, to decide the extent to which any benefits are received and by whom.

Where a wide discretion is conferred on the trustees, the settlor may provide a “Letter of Wishes” with specific guidance on how to manage and administer the trust fund. Alternatively, any decisions as to what, if any, benefits should be given to each of the beneficiaries can be left entirely at the trustees’ discretion.

When setting up a discretionary trust there is no need to decide who will benefit, what they will receive or when they will get it. You will only need to establish a defined class of beneficiaries, for example, all grandchildren. In this way the discretionary trust can cover different generations.

The discretionary trust in practice

The discretionary trust is suitable for those who wish to make a gift either during their own lifetime or on death, but have not yet decided who should eventually benefit, or in what proportions. The flexibility of the discretionary trust structure can also provide practical financial solutions, in particular in the context of asset protection and estate planning.

Asset protection and the discretionary trust

The discretionary trust can help to preserve your wealth by protecting assets from relationship property claims, particularly as family structures can be complicated by divorce and second marriages.

By transferring assets to a discretionary trust, the assets become the property of the trustees that, usually, cannot be brought into account in the case of a claim by the former spouse or partner of any family member in line to inherit.

The discretionary trust can also be used to protect assets against spendthrift beneficiaries, providing long-term protection where you have concerns about how family members may manage their financial affairs. Again, by taking advantage of the flexibility offered by the discretionary trust, the income or capital needs of relatives can be met as these needs arise.

Estate planning and the discretionary trust

In the context of estate planning, a discretionary trust can be an effective way to gift family assets, such as your family home, but with some flexibility as to who should eventually benefit and in what proportions.

By establishing a class of beneficiaries under a discretionary trust, you can also accommodate the birth of any additional descendants, for example, all great grandchildren, so long as they fall into a designated class of beneficiaries.

The discretionary trust and inheritance tax

Unfortunately, a discretionary trust does not offer the same tax advantages as other types of trust. The creation of a discretionary trust, when set up inter vivos rather than by will, is classed as a chargeable lifetime transfer. As such, the discretionary trust will potentially attract an immediate entry charge, with a further charge if the settlor dies within 7 years.

Unless specifically exempt, discretionary trusts are also subject to what is known as the “relevant property tax regime”. This imposes a number of additional charges on all relevant property during the lifetime of the trust.

These periodic and exit charges are payable when a discretionary trust reaches a 10-year anniversary, or where part or all of the trust fund is distributed.

The discretionary trust and other types of trust

Notwithstanding some of the tax disadvantages, the discretionary trust remains a popular choice of trust because of the degree of flexibility that it permits over what happens to assets after death. Other principal types of trust include the bare trust, the interest in possession trust and the mixed trust.

A bare trust is the simplest kind of trust available. Here assets are held for the beneficiary absolutely until they attain the age of 18. The bare trust creates a fixed and absolute interest in the trust fund. Typically neither the beneficiaries, nor the share in which they benefit, can be altered once the trust has been established. The beneficiary also has an absolute entitlement to demand their share of the trust fund having reached the age of majority.

An interest in possession trust gives the beneficiary an entitlement to receive any income from, or to use property comprised in, the trust for a defined period. Where this is for the life of the beneficiary, the interest in possession ends on their death, at which stage the trust assets will pass absolutely to another beneficiary or class of beneficiaries.

A bare trust is often used to hold investments for children, or to pass on assets on death, especially where the beneficiaries are still minors. It is also a suitable way to pass assets directly to your adult children. An interest in possession trust is useful if you want to provide your spouse or partner with a lifetime income or benefit after your death, with your assets to be later passed to your children.

However, a mixed trust can often be the best way of achieving the desired results. This combines the characteristics of different trusts that can be specifically tailored to your individual circumstances.

By way of example, an accumulation and maintenance trust can make provision for children and young adults up to the age of 25. The trust initially operates as a discretionary trust, where trustees are given discretion over how to use the income for the benefit of the child up to a specified age. Thereafter, the trust is converted into an interest in possession trust, allowing the beneficiaries automatic right to the trust funds.

Seeking legal advice in relation to discretionary trusts

By creating a trust you are relinquishing legal ownership of your assets, which, in the absence of clear financial goals, may prove to be detrimental to your own interests. Further, the financial and practical consequences of setting up a trust incorrectly can be significant, for both you and any intended beneficiaries.

If you are considering setting up a discretionary trust, you should always seek professional legal advice from a specialist in wills, trusts and taxation. Your expert legal adviser can help you to identify the most suitable type of trust, tailored to your particular set of circumstances. S/he can also be appointed as one of the trustees, to assist with the effective administration of your new trust.

Legal disclaimer

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.

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