Many families wish to protect wealth for their children and future generations, whilst retaining flexibility to adapt to changing circumstances. Discretionary trusts are a popular solution, as they allow trustees to manage inheritances in line with beneficiaries’ needs, shield assets from relationship breakdown or insolvency, and preserve the estate within the bloodline.
However, discretionary trusts can interact awkwardly with the Residence Nil Rate Band (RNRB). This article will examine how Discretionary Trusts and RNRB operate and practical options for combining the two.
What Does a Discretionary Trust Offer?
A discretionary trust gives trustees wide discretion over which beneficiaries receive funds, when, and on what terms. The benefits include:
- Trustees can respond to beneficiaries’ needs, tax rates, and family dynamics after death.
- Trust assets are better shielded from claims arising from divorce, bankruptcy, or reckless spending.
- Rather than a fixed-age inheritance, trustees can make needs-based or phased appointments.
These features make discretionary trusts attractive where the aim is to safeguard the estate after death.
Understanding RNRB
The RNRB is an additional inheritance tax allowance of up to £175,000 per person, available when a “qualifying residential interest” (usually the main residence) is “closely inherited” by lineal descendants (including children, stepchildren, adopted and foster children, and their descendants). Any unused RNRB on the first death may be transferred to the surviving spouse or civil partner.
Key features include:
- The residence (or a share of it) must pass to lineal descendants outright or via certain types of trust which include an Immediate Post-Death Interest (IPDI) trust for a lineal descendant.
- The RNRB tapers away for estates exceeding £2 million (on second death, before reliefs).
- Relief can still apply where a residence has been sold or downsized, provided conditions are met.
It is important to note that a discretionary trust does not, by itself, meet the “closely inherited” requirement on the second death even if all the potential beneficiaries are descendants. Without action, this can result in the loss of the RNRB increasing IHT liability.
Preserving the RNRB When Using a Discretionary Trust
There are a number of planning tools to reconcile a discretionary trust with the RNRB:
1. Appointment within Two Years (S144 IHTA 1984)
If the residence (or a share) falls into a discretionary trust on second death, the trustees can appoint it to lineal descendants within two years of death. RNRB can be made retrospectively available due to the operation of S144 of the Inheritance Tax Act 1984.
S144 treats certain post-death distributions made within two years as if they had been made by the deceased under the will at the date of death. In practical terms, if trustees of a discretionary will trust appoint capital or create an IPDI for a beneficiary within two years, S144 “reads back” that appointment into the will for IHT purposes. This can convert what would otherwise be a non-qualifying discretionary structure into a qualifying disposition for RNRB, as the appointment is treated as a direct gift to lineal descendants.
This approach preserves flexibility at death, but places a time-critical duty on trustees and advisers to act.
Where the residence passes into a discretionary trust, a letter of wishes should guide trustees on whether to appoint within two years to lineal descendants to secure the RNRB. While not legally binding, this ensures trustees are fully aware of the client’s intentions and highlights the need to act within two years.
Example:
On second death, the estate (including a £500,000 home) passes into a discretionary trust. The available RNRB is £350,000 (including transferable RNRB). Within 18 months, trustees appoint a 70% share of the home to the two children. Section 144 reads this back into the will, the RNRB is preserved, and the remaining 30% stays protected in trust.
2. Outright Gift of an RNRB-Sized Share
Alternatively, the will can provide that an amount up to the available RNRB passes outright to lineal descendants, with the residue (including the balance of the home) passing to a discretionary trust. Formula clauses are available to accommodate this, including any potential downsizing addition.
As the descendants receive a qualifying interest outright, the “closely inherited” test is met without relying on post-death appointments. However, this does sacrifice asset protection on the gifted portion.
Example:
A testator’s will includes a formula RNRB gift to her children outright, with the remainder of the estate to a discretionary trust. Her estate is £1.4 million, including her main residence valued at £600,000. She has a full transferable RNRB from her late spouse. The RNRB is secured automatically. A share worth £350,000 passes outright to the children, with the remainder of the estate to a discretionary trust. The bulk of the estate remains protected.
3. IPDI for a Lineal Descendant
An IPDI is a form of life interest created by will on death, giving a named beneficiary an immediate right to the income or enjoyment of the trust fund. For RNRB purposes, an IPDI in favour of a lineal descendant generally counts as “closely inherited”.
A hybrid structure can be used to offer both RNRB availability and asset protection. An IPDI can be created over a defined share of the property to secure the RNRB, with the remainder of the estate (and any balance of the property) passing to a discretionary trust.
This gives greater certainty than relying on a two-year appointment, maintains some protection because the capital is protected, whilst ensuring RNRB is available.
There are, however, downsides. An IPDI is generally less flexible than a discretionary trust (although overriding powers can be included), and the entitlement to income means any income could be considered in the event of relationship breakdown or similar. The IPDI share is also within the estate of the beneficiary for IHT purposes. It also adds drafting complexity.
Example:
The testator’s will grants his daughter an IPDI over a share in the home equal to the RNRB, with the remainder of the estate to a discretionary trust for his descendants. The estate is £1.1 million, including a home worth £500,000. He has a full transferable RNRB.
This leads to a share of the property equal to £350,000 passing to the IPDI. This qualifies as “closely inherited” by a lineal descendant, securing the full RNRB. The balance of the estate passes to a discretionary trust. On the daughter’s eventual death, the IPDI fund forms part of her estate for IHT.
Discretionary Trusts and RNRB Conclusion
Discretionary trusts remain a valuable tool for families seeking both flexibility and asset protection, benefits that outright gifts cannot offer. However, it is important to be aware that a discretionary trust does not automatically meet the “closely inherited” condition for RNRB. With careful will planning or timely post-death action, it is possible to achieve both protection and IHT efficiency. Clear planning and trustee guidance are essential to ensure that Discretionary Trusts and RNRB are combined effectively.
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