Key takeaways
- Understand what a Discretionary Trust is and its most common uses
- The tax treatment of Discretionary Trusts
What is a Discretionary Trust?
With a Discretionary Trust, the Trustees are given total control over the assets as well as the income generated. Under a Discretionary Trust, the Beneficiaries do not have an automatic right to receive the assets within the trust. Instead, the Trustees determine (at their ‘discretion’) when to divide the assets and how much each Beneficiary will receive.
The most common uses of a Discretionary Trust
Discretionary Trusts are often used when the Settlor wants to create a trust for minors (such as their grandchildren) and want to name Trustees (such as the parents of the grandchildren) who will exercise full control of the trust and its assets. Discretionary Trusts often are accompanied by a letter where the Settlor gives the Trustees guidance on their wishes.
Discretionary Will Trusts were commonly used in Inheritance Tax planning to ensure married couples both took advantage of their nil-rate bands. On the death of the first spouse, an amount up to the nil-rate band was placed in trust for which the survivor was also a Beneficiary, with the balance of the estate passing free from Inheritance Tax to the surviving spouse.
However, since October 2007, it has been possible for the nil-rate band of the deceased spouse/civil partner to be claimed by the survivor. As a result, there is less need for this type of trust arrangement.
Discretionary Trusts can still be used for estate planning where the Settlor expects investments in the trust to grow at a faster rate than the Inheritance Tax nil-rate band (which has stood at £325,000 since April 2009).
Administration of the Discretionary Trust
Discretionary Trusts can be created during a person’s lifetime or upon death.
The trust may include named Beneficiaries, but often instead reference classes of potential beneficiaries such as children, grandchildren, as well as other family members.
As the named Trustees have full control over who benefits from the trust, Beneficiaries do not have any automatic entitlement to trust income or capital. Trustees are able to determine:
- The amount of income paid out by the trust
- Which beneficiaries income payments are made to
- When and how often any income payments are made
Trustees can also choose to accumulate income within the trust, rather than make distributions.
In most circumstances, the Settlor will also be a named Trustee, giving them the ability to ensure the discretionary powers of Trustees are exercised appropriately and in line with their stated wishes. Such wishes are normally referenced in a “Letter of Wishes’. Although this is not a legally binding document, it provides Trustees with clear guidance in discharging their responsibilities.
Tax treatment of trusts
Discretionary Trusts fall within ‘the relevant property regime’ which means they are subject to Inheritance Tax, which can add a further degree of complexity.
Advisers should understand the tax treatment of Discretionary Trust creation, in operation and when Trustees distribute assets, particularly as this could influence the choice of investment vehicle used by the Trust.
Settling assets into a discretionary trust (Entry Charge)
Lifetime gifts settled into Discretionary Trusts are classed as Chargeable Lifetime Transfers (CLTs). These are immediately chargeable and may also become chargeable again on the death of the person making the transfer.
Inheritance Tax will be charged at the ‘lifetime rate’ of 20% on amounts above the Settlor’s nil-rate band in a 7-year rolling period.
However, there is no 20% lifetime tax on Discretionary Will Trusts, as the estate pays the Inheritance Tax at the ‘death rate’ of 40% on amounts over the available nil-rate band.
Advisers should note that if the Settlor also pays the tax, this is considered as a further gift by HMRC, and the tax must be grossed-up to value the ‘loss’ to their estate. This takes the effective rate paid up to 25%.
The nil-rate band available to the Settlor is reduced by the value of any other chargeable transfers made by the Settlor in the previous seven years.
Additional Inheritance Tax may be payable if the Settlor dies within seven years of creating the trust. In this event, the gift will become chargeable at the death rate of 40%, and Potentially Exempt Transfers (PETs) made within seven years of the settlor’s death must be taken into account.
As the name suggests, a PET is potentially exempt from IHT if the donor survives the gift by seven years. However, should they die within seven years of making the gift, it becomes a chargeable transfer. There’s a reduction – known as ‘Taper Relief’ – on the amount of tax payable should death occurs after three but before seven years.
We cover PETs in more detail here.
Telling HMRC about potentially chargeable events via IHT100
When the Settlor reaches the IHT100 reporting limits for gifts into a Discretionary Trust, they must notify HMRC. HMRC will then decide whether exemption will be given. This reporting limit is usually met when the Settlor has made cumulative gifts valued at 100% of the nil-rate band.
This Link on Gov.uk provides further guidance on IHT100 reporting requirements.
The ten-year Periodic Charge
Discretionary Trusts are ‘Relevant Property’ trusts. As trust assets are not included in the taxable estate of any of the Beneficiaries, the trust itself will be assessed for Inheritance Tax every ten years. This is known as the ‘Periodic’ or ‘Principal’ charge.
On ten-year intervals from the date the trust was created, the trust is taxed on the value of the trust minus the nil-rate band available to the trust. The rate paid on the excess is no more than 6% (calculated as 30% of the Lifetime Rate which is 20%).
If the value of the trust is less than the available nil-rate band, there is no Periodic charge due for that period.
Payments of capital out of the trust (Exit Charge)
Eddie made a PET on 1 October 2008, subject to the seven-year rule. The trust fund is within the IHT estate of Janet. As a result of the Transitional Serial Interest rules, the trust is treated as pre-22 March 2006 and is not subject to the relevant property regime.
An ‘Exit Charge’ is calculated when capital (not income) is distributed to a Beneficiary. The rate of tax applied to the capital leaving the trust is based on:
- Exits recorded in the first ten years. The rate is calculated on a notional chargeable transfer of the trust assets immediately after they settled into trust. The effective rate is calculated based on notional tax charge of 30% of lifetime rate of 20% even if the trust was created on death.
- Exits recorded after the first periodic charge date. The rate of tax applied at the last ten year anniversary is recalculated using the nil-rate band at the time of exit.
In both cases, the rate is apportioned based on the number of quarters (three-month periods) elapsed since the trust’s inception or its last ten year anniversary.
In most instances, where no tax was due on creation of the trust, there is no Inheritance Tax liable on any distributions made in the first ten years. However, there are several exceptions:
- Where the Settlor dies within seven years of an earlier PET
- Where an exemption applies to reduce the Settlor’s Inheritance Tax as Exit Charges are based on the value to Trustees
- Where an asset that benefited from Business Relief or Agricultural Relief no longer qualifies, or has disposed of
- In cases where the trust is a Discretionary Will Trust (where the transferable nil-rate band is available) Periodic Charges and Exit Charges are only calculated using the standard nil-rate band
Also, with Discretionary Will Trusts there is no Inheritance Tax Exit Charge on distributions within two years of the Settlor’s death (these distributions are instead treated for Inheritance Tax purposes as having been made by at the time of the Settlor’s death).
We cover gifts and exemptions from Inheritance Tax in more detail here.
Income tax treatment
The first £1,000 of trust income is taxed at the ‘standard’ rate of Income Tax (20%), with income from dividends taxed at 8.75%. This is split between the number of trusts created in the settlor’s lifetime up to a maximum of five. Everything over £1,000 is taxed at the rate applicable to trustees which is 45% and for dividends is 39.35%. However, the 2023 Spring Budget abolished the Standard Rate threshold of £1,000 with effect from April 2024 and as a result, all trust income will be taxed at 39.35% for dividends, and 45% for income.
Taxation of a beneficiary
When the Beneficiary receives income from a Discretionary Trust this is classed as non-savings income. They can claim a 45% tax credit in part or in full, depending on their tax position (a non-taxpayer could reclaim the full £450 tax credit, while basic rate and higher rate taxpayers can reclaim £250 and £50 respectively).
This Link on Gov.uk provides further guidance on reporting trust income using the R185 form.
Settlor interested trusts and parental settlements
Trust income will be considered as the Settlor’s if they or their spouse or civil partner, or minor unmarried children can benefit from the trust. This does not include former spouses or civil partners, meaning a trust set up for a widow or widower would not be affected.
Trustees are required to deduct tax at the trust rate.
Any tax reclaimed by the Settlor must be repaid to the Trustees. As this is not considered to be a discretionary payment to the trust, it will not have a transfer of value for Inheritance Tax purposes.
A Beneficiary receiving income from the Trustees does not have any further Income Tax liability, but they will not be able to reclaim any of the tax paid.
Capital Gains Tax treatment of gifts into a Discretionary Trust
Lifetime gifts into trust, apart from cash gifts or the assignment of investment bonds, are considered as disposals for Capital Gains Tax (CGT) purposes.
Any capital gains will be assessed on the Settlor unless they have chosen to ‘holdover’ the gain. This will postpone taxation on the gain until the Trustee sells the assets or transfers them to the Beneficiary.
Holdover relief is not applicable in cases where the Settlor, their spouse/civil partner or their minor unmarried children can benefit from the trust (also called ‘Settlor Interested’ trusts).
Assets transferred to the trust on the Settlor’s death will not usually have been subject to CGT, as the Trustee acquires the assets at their market value on the date of death.
Disposal of trust assets
Where the Trustee has disposed of trust assets (for example, having sold an investment fund or a property) capital gains are calculated in the same way as for an individual and taxed at the trust rates of CGT (20% or 28% for residential property).
Trustees are entitled to half of the individual annual CGT exempt amount, and this exemption is shared equally between all trusts created by the same Settlor in his lifetime, subject to a minimum of one-fifth of the trust exemption.
Transfers out of trust
Where the Trustee transfers chargeable assets to a beneficiary – such as making a discretionary payment of capital to a Beneficiary – there will be a CGT charge.
Trustees can coordinate with the Beneficiary for the gain to be held over (postponed until the Beneficiary ultimately disposes of the asset (except on their death). This is possible even where the trust is Settlor interested
This is particularly useful where the Beneficiary has the full annual exemption and may pay a lower rate of CGT compared to the Trustee.
When using holdover relief, the Trustee must be careful to not pass assets to the Beneficiary within the first three months following the creation of the trust, or within the first three months following a ten-yearly Periodic Charge. In both instances, holdover relief would not apply unless the transfer involved business assets.
Conclusion
Discretionary trusts are some of the most flexible trusts available, given Trustees full discretion over how trust capital and income is managed and distributed. But this added flexibility comes with a downside, as Discretionary trusts are subject to the more costly relevant property regime for Inheritance Tax purpose, meaning gifts into them are chargeable transfers and the trust may be subject to periodic and exit charges. Trust income and capital gains are also subject to the trust rates of tax.
