Discretionary Trusts Explained: Flexibility and Asset Protection

Discretionary trusts offer unparalleled flexibility in how assets are distributed to beneficiaries. But this flexibility comes with complex tax rules that require careful planning.

What Is a Discretionary Trust?

A discretionary trust is a type of trust where trustees have complete discretion over how to distribute income and capital among a class of beneficiaries. No beneficiary has an automatic right to any trust assets.

Key features include:

• Trustees decide who gets what, when, and how much
• Beneficiaries have no fixed entitlement
• The trust document usually names potential beneficiaries (the "class")
• Assets are protected from beneficiaries' creditors and divorcing spouses

How Discretionary Trusts Work

The Settlor

The person who creates the trust and transfers assets into it. Once assets are in the trust, the settlor generally shouldn't benefit from them (or else HMRC may treat them as still belonging to the settlor).

The Trustees

Those responsible for managing the trust assets and making distribution decisions. They must act:

• In the best interests of beneficiaries
• According to the trust deed
• Prudently and with proper care

The Beneficiaries

The class of people who may benefit from the trust. This could be:

• Named individuals (your children by name)
• A defined class (all your grandchildren, including future ones)
• Charity as a beneficiary of last resort

Letter of Wishes

While not legally binding, settlors often write a letter of wishes explaining their intentions. This guides trustees without restricting their discretion.

Benefits of Discretionary Trusts

1. Maximum Flexibility

Circumstances change. A discretionary trust can respond to:

• A beneficiary's changing needs
• New family members (grandchildren not yet born)
• Changed financial circumstances
• Relationship breakdowns

2. Asset Protection

Because beneficiaries don't own trust assets:

• Assets generally aren't available to a beneficiary's creditors
• In divorce, trust assets aren't automatically part of the matrimonial pot
• If a beneficiary goes bankrupt, the trustee in bankruptcy cannot claim trust assets

3. Protection from Beneficiaries

Trustees act as guardians, preventing:

• Imprudent spending by immature beneficiaries
• Exploitation by third parties
• Loss of means-tested benefits for vulnerable beneficiaries

4. Privacy

Unlike wills, which become public after probate, trusts remain private. Beneficiaries don't necessarily know the full extent of trust assets or who else might benefit.

Tax Rules for Discretionary Trusts

Discretionary trusts fall under the "relevant property regime" for inheritance tax, which has three main charges:

Entry Charge

When you transfer assets into a discretionary trust during your lifetime:

• Transfers up to your available nil rate band (£325,000): No charge
• Transfers above the nil rate band: 20% immediate charge
• If you die within 7 years: Additional IHT may be due

Example: You transfer £500,000 into a discretionary trust. After using your nil rate band, £175,000 is chargeable. The immediate tax is £35,000 (20% of £175,000).

10-Year Anniversary Charge

Every 10 years, the trust is valued and a charge applies:

• Maximum rate: 6% of trust value above the nil rate band
• Actual rate depends on various factors
• Typically works out at 1-6% of the trust value

Exit Charge

When assets leave the trust (distributed to beneficiaries):

• A proportionate charge based on time since creation or last 10-year anniversary
• Usually a fraction of what the 10-year charge would have been

Income Tax

Income retained in the trust is taxed at:

• 45% on interest, rent, and other income
• 39.35% on dividends

When income is distributed, beneficiaries receive a 45% tax credit. Those paying less tax can reclaim the difference.

Capital Gains Tax

• Annual exemption: £1,500 (half the individual allowance)
• Rate: 20% (28% for residential property)
• Transferring assets to beneficiaries can trigger CGT on gains

When to Use a Discretionary Trust

Ideal Situations

• Young or immature beneficiaries: When you don't want children to inherit outright at 18
• Vulnerable beneficiaries: Those receiving means-tested benefits or unable to manage money
• Uncertain circumstances: When you don't know which beneficiaries will need help most
• Asset protection: Concerns about divorce, bankruptcy, or third-party claims
• Business succession: Controlling family company shares across generations

Less Suitable Situations

• Simple estates: When a straightforward gift or will would suffice
• Small amounts: Administration costs may outweigh benefits
• When beneficiaries are known and stable: Other trust types may be more tax-efficient

Setting Up a Discretionary Trust

During Lifetime

Steps to create a lifetime discretionary trust:

1. Decide what assets to transfer (considering IHT implications)
2. Define the class of beneficiaries carefully
3. Choose suitable trustees (consider professional trustees for large trusts)
4. Have a solicitor draft the trust deed
5. Transfer assets into the trust
6. Register with the Trust Registration Service

In Your Will

A discretionary trust created by will (often called a "will trust") comes into effect on death. It's commonly used for:

• Protecting inheritance for minor children
• Providing flexibility about who benefits
• Nil rate band discretionary trusts (for IHT planning)

Ongoing Administration

Discretionary trusts require active management:

Trustee Duties

• Hold regular meetings (at least annually)
• Review beneficiaries' needs
• Make and document distribution decisions
• Manage investments prudently
• Keep accurate accounts

Compliance Requirements

• Register with Trust Registration Service
• File annual tax returns if there's income or gains
• Calculate and pay any 10-year or exit charges
• Maintain records for at least 6 years

Alternatives to Discretionary Trusts

Bare Trusts

Simpler and more tax-efficient, but beneficiary has absolute right at 18.

Interest in Possession Trusts

Give one person the right to income while preserving capital for others. More tax-efficient for some situations.

Life Insurance Trusts

Often discretionary trusts holding life insurance policies, but with simplified administration.

Getting Professional Advice

Discretionary trusts are powerful but complex. Professional advice is essential for:

• Determining if a discretionary trust is the right structure
• Drafting the trust deed correctly
• Understanding tax implications of different scenarios
• Ongoing administration and compliance

The cost of professional advice is usually worthwhile given the tax penalties for getting it wrong.