Discretionary trusts are commonly used trusts with a large number of different uses. In this week’s article we look at what a discretionary trust is and why you might wish to use one in a will.
What is a Discretionary Trust?
A discretionary trust is a trust where the beneficiaries of the trust have no right or entitlement to the income or capital of the trust. They merely have a chance that they may benefit from the trust. Instead the trustees of the discretionary trust have complete discretion over how the income and capital of the trust is applied. They will decide at their discretion which beneficiaries will benefit, how much they will receive and when they will receive it.
Due to the trustees’ complete discretion over the trust assets, it is advisable that the testator writes a letter of wishes to store with their will guiding the trustees and informing them of any particular concerns. It should be remembered however that letters of wishes are not legally binding and the trustees are under no obligation to follow them.
Discretionary trusts can last up to 125 years and due to perpetuity rules, they cannot be written to last any longer. They can be ended earlier than 125 years, for example if the trustees distribute all the trust capital to the beneficiaries or if all the potential beneficiaries have died.
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.
Discretionary trusts are relevant property trusts for inheritance tax purposes. This means that anniversary and exit charges will apply when the trust has capital above the nil rate band.
Why use a Discretionary Trust?
Protection of beneficiaries is one of the most common uses for a discretionary trust. This may be protection from themselves or from third parties.
One of the chosen beneficiaries may, for example, have divorce proceedings pending or be at risk of bankruptcy. Giving to this beneficiary outright could lead to their inheritance being lost through those proceedings. Alternatively, a beneficiary may be a spendthrift or has drink, drug or gambling problems and the testator may not trust them to inherit a large sum of money.
Rather than giving to that beneficiary outright, the testator could instead gift to a discretionary trust with that person as a potential beneficiary. Whilst their issues are ongoing, the trustees could provide occasional benefits (for example to pay for rehab or towards solicitors’ fees in a divorce). Once the trustees deem it appropriate to do so, they could then pass that beneficiary’s inheritance to them.
Alternatively due to the trustees’ wide powers, a discretionary trust might be used due to its flexibility. Discretionary trusts may be used to hold assets for disabled beneficiaries who may lack the ability to deal with them themselves, or alternatively may need an inheritance drip fed to them to avoid losing benefits. Depending on the beneficiary’s circumstances, a disabled persons trust may be a better option for them.
Some of the beneficiaries may have their own inheritance tax issues that they do not want to worsen. Discretionary trusts are their own legal entity for inheritance tax purposes, so an inheritance could be passed to the trust. The trustees could then provide occasional benefits or loans to that beneficiary rather than receiving their inheritance outright.
Where a testator is likely to want to amend their distributions often, but the beneficiaries are unlikely to change, they could consider passing to a discretionary trust. Rather than rewriting their will every time they wish to change, they could simply amend the distributions in the letter of wishes. The will would however need rewriting to add beneficiaries to the trust.