Discretionary trusts are a popular and powerful tool in estate planning, valued for their flexibility and the control they offer over family wealth. Unlike fixed trusts, where beneficiaries have a set entitlement, discretionary trusts give trustees the authority to decide how, when, and to whom income and capital are distributed among a class of potential beneficiaries. This means no beneficiary has an automatic right to the trust assets, allowing trustees to adapt to changing circumstances and act in the best interests of the family.

Key Benefits and Common Uses

The main advantage of a discretionary trust is its adaptability. Trustees can respond to life’s uncertainties—such as changes in family structure, financial hardship, or the emergence of new needs—without being bound by rigid instructions. This is especially useful for:

• Families with young children, where future needs are unknown.

• Beneficiaries who are vulnerable, have disabilities, or struggle to manage money.

• Protecting assets from beneficiaries’ creditors, divorce settlements, or bankruptcy.

• Managing business assets for the benefit of the family, ensuring continuity and professional oversight.

• Providing for future generations, as the trust can last up to 125 years.

Discretionary trusts are also commonly used to delay the distribution of assets until beneficiaries reach a certain age or milestone, or to provide ongoing support for a beneficiary with fluctuating needs.

Tax Implications: What You Need to Know

While discretionary trusts offer many benefits, their tax treatment is often misunderstood and can be a source of confusion. Most fall under the “relevant property regime” for Inheritance Tax (IHT):

• Entry Charge: If you transfer assets into a discretionary trust during your lifetime and the value exceeds the nil rate band (currently £325,000), a 20% IHT charge may apply immediately. Many people are caught out by this, assuming gifts into trust are always tax-free.

• Ten-Year (Periodic) Charge: Every ten years, the trust may face a charge of up to 6% on the value of assets above the nil rate band. This can erode the value of the trust over time if not planned for.

• Exit Charge: When assets leave the trust, a proportionate IHT charge may apply.

For income tax, discretionary trusts are taxed at the “trust rate” (currently 45% for most income, 39.35% for dividends), which is higher than most individuals’ rates. Trustees must provide tax vouchers to beneficiaries, who may be able to reclaim some tax depending on their own circumstances. Capital Gains Tax (CGT) also applies, with a lower annual exemption than for individuals.

A common pitfall is failing to plan for these charges, which can significantly reduce the long-term value of the trust. Regular reviews and careful record-keeping are essential.

Trustee Selection and Ongoing Management

Choosing the right trustees is crucial. Trustees have significant discretion and responsibility, so select individuals who are trustworthy, financially astute, and able to work together. You can appoint professional trustees, family members, or a combination. It’s wise to provide a letter of wishes to guide your trustees, explaining your intentions and priorities. While not legally binding, this document can help avoid misunderstandings and disputes.

Trustees must act in the best interests of all potential beneficiaries, keep accurate records, and ensure compliance with trust law and tax obligations. They should also have suitable investment powers to manage trust assets effectively. If the trust holds business or investment assets, consider whether the trustees have the necessary expertise or if professional advice is needed.

Common Pitfalls and How to Avoid Them

• Unclear class of beneficiaries: Define the class of beneficiaries clearly in the trust deed to avoid disputes or unintended exclusions.

• Outdated trust arrangements: Family circumstances and tax laws change. Review the trust regularly to ensure it still meets your objectives.

• Inadequate guidance for trustees: A detailed letter of wishes can help trustees make decisions in line with your values.

• Ignoring tax charges: Plan for entry, periodic, and exit charges, and keep up to date with changes in tax law.

Conclusion

Discretionary trusts offer unrivalled flexibility and protection for family wealth, but they require careful management and ongoing review. By understanding the tax implications, choosing the right trustees, and providing clear guidance, you can ensure your trust continues to meet your objectives and adapt to life’s changes.

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Disclaimer: This blog post provides general information for educational purposes only. It is not legal advice. Outcomes can vary based on your personal circumstances.