What is a Discretionary Trust?

In the UK, a discretionary trust is a flexible type of trust in which the trustees have the power to decide how to allocate the trust’s income and/or capital among a group of potential beneficiaries. Unlike a bare trust, where beneficiaries have an absolute right to the assets, the beneficiaries of a discretionary trust only have a potential right to benefit, subject to the trustees’ discretion.

You can open a bank account for a discretionary trust here.

Key Features of a Discretionary Trust:

1. Trustees’ Discretion:
   • Trustees have the authority to decide:
     • Which beneficiaries receive income or capital.
     • How much each beneficiary receives.
     • When beneficiaries receive their entitlement.
   • This allows the trustees to respond to changes in circumstances, such as beneficiaries’ financial needs or tax situations.
2. Beneficiaries:
   • The trust usually has a class of beneficiaries, which may include specific individuals (e.g., children, grandchildren) or broader categories (e.g., “my descendants”).
   • No beneficiary has an automatic right to the assets—they are only entitled to what the trustees choose to distribute to them.
3. Flexibility:
   • The flexibility of discretionary trusts makes them suitable for protecting assets and managing the needs of multiple beneficiaries, especially if those needs are uncertain or change over time.
4. Letter of Wishes:
   • The settlor (the person creating the trust) can provide a letter of wishes to guide the trustees on how they might exercise their discretion. While not legally binding, it serves as a reference point for the trustees.

Taxation of Discretionary Trusts in the UK:

Discretionary trusts have distinct tax rules compared to other trusts:

1. Income Tax:
   • Income retained within the trust is taxed at the trust rate:
     • 45% on most income.
     • 39.35% on dividend income.
   • If the income is distributed to beneficiaries, they may reclaim some of the tax paid, depending on their personal tax rates.
2. Capital Gains Tax (CGT):
   • Trustees are liable for CGT on gains made by trust assets, taxed at 20% (or 28% for residential property).
   • Trustees have a reduced annual CGT exemption, currently 50% of the standard individual allowance.
3. Inheritance Tax (IHT):
   • Discretionary trusts are subject to a periodic charge (up to 6% of the value of the trust assets) every 10 years.
   • An exit charge may also apply when assets leave the trust (e.g., distributed to beneficiaries).

Common Uses of Discretionary Trusts:

1. Asset Protection:
   • Trust assets are protected from the creditors or divorce settlements of beneficiaries.
   • Suitable for beneficiaries who are vulnerable, financially inexperienced, or have special needs.
2. Tax Planning:
   • Helps manage and minimize inheritance tax (IHT) exposure.
   • Flexible for distributing income and capital in tax-efficient ways to beneficiaries.
3. Providing for Multiple Generations:
   • Ideal for families where the settlor wishes to benefit descendants but does not want to divide the assets outright.

Example:

A parent sets up a discretionary trust for their children and grandchildren. The trustees are given the discretion to allocate trust income or capital to support beneficiaries’ education, medical expenses, or other needs. One child might receive a larger share for university tuition, while another might receive nothing if they are already financially secure.

Discretionary trusts are popular for their flexibility and protective features, but they come with administrative responsibilities and specific tax implications. Trustees must carefully manage the trust in line with both legal obligations and the settlor’s intentions.