In this article we will discuss some key facts of discretionary trusts, including why they are used, how they are taxed, and some basic requirements for them to be valid.
Is it possible to have a discretionary trust for one person?
The trustees must have a discretion over what beneficiary to benefit, therefore a discretionary trust needs to have more than one beneficiary, or at least the chance that the class of beneficiaries might increase in the future. For example, if the client has just one child and the class of beneficiaries was referred to as ‘my descendants’, this would be acceptable as there could be potential beneficiaries in the future for the trustees to consider.
How is a discretionary trust taxed?
Discretionary trusts are subject to the relevant property regime. This will mean that if the trust’s assets are over the nil rate band (currently £325,000) the trust will need to pay anniversary and exit charges on the assets over the nil rate band. How these charges are calculated is complex but combined these charges will not exceed 6% of the value of which is above £325,000.
If the value of the trust is below the nil rate band, there will be no ongoing inheritance tax charges.
For inheritance tax purposes, the trust assets are seen as owned by the trust rather than by the beneficiaries of the trust.
Why use a discretionary trust?
The reasons to use a discretionary trust usually come down to either:
- Protection: This may be protecting the beneficiaries from themselves, for example due to addiction concerns, or from third parties such as a potential divorce or bankruptcy.
- Flexibility: This could be flexibility for beneficiaries, such as a beneficiary who lacks financial ability to manage the inheritance themselves, or for flexibility for the testator for example if they may want to amend the distribution of the estate often (but the beneficiaries will remain the same).
Our previous article covers this in more detail.
How long can a discretionary trust last?
Discretionary trusts are usually written to last for 125 years, it is not possible for them to last any longer than this. The trust could be ended earlier than this, for example if all the beneficiaries have died (in which case the trust assets would pass to the default beneficiaries) or by the trustees distributing all the trust assets out to the beneficiaries.
What should the letter of wishes be used for?
The trustees of a discretionary trust have complete discretion on how to use the trust assets. Therefore, the trust itself won’t specify the distribution of the trust assets, such as what percentages the clients would want the beneficiaries to inherit or any other particular wishes they may have
Any particular wishes on how the trustees should exercise their discretion should instead be kept in a separate letter of wishes to the trustees. This can include wishes should as how much each beneficiary should inherit, at what ages and any concerns the testator may have over how the beneficiaries should inherit. The trustees would consider this letter but it is non-binding.
Can the Residential Nil Rate Band apply to a discretionary trust?
The Residential Nil Rate Band (RNRB) cannot apply if it is intended that the deceased’s main residence forms part of a discretionary trust and is to remain in the trust for the long term. However, if the trustees of the trust appoint the home out of the trust to direct descendants within two years of the testator’s death, RNRB will then apply. This is due to rules contained in S144 Inheritance Tax Act 1984 which mean that distributions from the trust within two years of death are treated for IHT purposes as if the will had gifted the assets to the beneficiary.