A guide to discretionary trusts

A trust is a legal arrangement in which assets are held by a person (or people), known as the trustee(s), for the benefit of one or more beneficiaries. There are different types of trust, each with their own unique characteristics, purposes, benefits and tax implications. A discretionary trust is a common type of trust.

A discretionary trust permits the trustee(s) discretion as to how they manage the trust. The trustees have a wide range of powers and are given total control over the assets within the trust. The beneficiaries have no legal entitlement to the assets and have no automatic rights (they have a possible opportunity to benefit only).

How are they set up?

A discretionary trust can be set up during a person’s lifetime or within their Will to take effect when they die. The trust is usually accompanied by a letter of wishes which outlines the objective of the trust and gives guidance as to how the trust should be operated and how and when the trustee(s) should manage and distribute the trust assets. The person setting up the trust is known as the settlor, and they will prepare the letter of wishes. A discretionary trust can be in existence for up to 125 years.

The trustee(s)

1. The role

The role of the trustee(s) is to hold and administer the trust assets for the use and benefit of the beneficiaries. The role does require a certain amount of involvement and adherence to general trust law and the specific terms of the trust. The trustee(s) will be the legal owner of any assets within the trust and will be responsible for decisions concerning the assets. A trustee is usually an individual, but it is possible to appoint a trust corporation.

2. Discretion

The trustee(s) must act in the best interests of the beneficiaries and should consider all beneficiaries when exercising their discretion. The trustee(s) will have power over both the income and capital of the trust and it is important that they remain objective and consider the wishes of the settlor. It is possible for a trustee to be a beneficiary of the trust; however, it is best practice to avoid any possible conflicts of interest and it is often a good idea to have at least one trustee who has no financial interest in the trust. For this reason, people sometimes choose to appoint an independent professional trustee such as a solicitor or accountant. If the trust is set up during the settlor’s lifetime, they themselves can be a trustee.

3. Investments

The trustee(s) must follow a strict process when choosing to invest trust assets. They must obtain and consider proper advice from a person qualified to give such advice and must also diversify the investments. The trustees can delegate their powers of investment to a professional asset manager.

4. Changing a trustee

The trustee(s) may change over the life of the trust and it is possible for new and/or replacement trustee(s) to be appointed and for the trustee(s) to be removed or retired. The trust will usually dictate who has the power to appoint new trustees.

Beneficiaries

A beneficiary of a discretionary trust can include both individuals and charities. Beneficiaries could include a class of people such as ‘grandchildren’. Beneficiaries can also include people not born yet. It is quite common for someone to stipulate the beneficiaries as their descendants which will include anyone born down their bloodline.

Advantages

There are situations in which a discretionary trust may be very advantageous and there are various benefits of setting one up. These can include:

Asset Protection

A key feature of a discretionary trust is that the beneficiary does not have an automatic right to the assets. This can provide protection of the assets until such time (if ever) the beneficiary is in a position to receive the asset outright – for example, if a beneficiary had a disability, was making poor life choices, struggling with an addiction, in a controlling or coercive relationship or simply too young. The trustees can hold the assets and make decisions as to appropriate things to spend the funds on for the beneficiaries. This may include medical treatment, education, accommodation, a vehicle, educational materials such as books, school trips, computer equipment and travel. The capital assets can be retained and used to generate an income for the beneficiaries.

Inheritance Tax

If a discretionary trust is set up during the settlor’s lifetime, the assets within that trust may fall outside their own estate if they die at least seven years after putting the assets into the trust. This will have the effect of reducing down the overall value of their estate when it is assessed for inheritance tax.

Flexibility

As the trustees are permitted complete discretion as to how the trust is managed, this allows for a great deal of flexibility. It may be that when the settlor makes their Will, they are unsure of exactly how things will look when they die. The flexible nature of a discretionary trust means that it can be updated to reflect changing circumstances. The letter of wishes can be updated as often as the settlor chooses without the need to alter the trust.

Privacy

When a person dies, in most cases their Will goes through the probate process and becomes a public record. Anyone is entitled to order a copy of a Will that has gone through the probate process. A letter of wishes is not a public document and will not form part of the public record. Therefore, a discretionary trust can be useful to keep specific details of how an estate is distributed out of the public eye, as if often the case with celebrities.

Tax consequences

There are various tax consequences of discretionary trusts and advice should always be sought and all options considered before proceeding. If the assets entering into the trust exceed the Inheritance Tax nil rate band, currently £325,000, an entry charge will occur as well as further charges every ten years (at a very low rate of Inheritance Tax) and when assets leave the trust. There may also be income tax, capital gains tax and stamp duty consequences to consider.

If assets are left to a discretionary trust under a Will, the assets will be taxed as part of the death estate (at 40% above any nil rate bands) but will not suffer any further ‘entry charge’. Assets distributed within two years of death will not suffer a tax charge on leaving the trust.

A discretionary trust is a flexible vehicle for protecting assets and keeping control of how and when they are distributed while potentially sheltering them from the death rate of Inheritance Tax. With the right structuring, a discretionary trust can be easy to administer and tax-efficient.

If you would like to know more about discretionary trusts or discuss how one may work for you, please contact Will Norton.