Discretionary Trust

Discretionary trusts are trusts that one can set up on behalf of one or multiple beneficiaries. The trustee overseeing the trust can utilize their discretion to decide which beneficiaries will receive income and capital from that trust. Moreover, they can determine when and how they receive the trust assets.

This trust is a valuable estate planning tool for individuals requiring additional assistance managing substantial funds. The trustee of such a trust has control over the assets. However, they cannot utilize the capital or income for their benefit. Also, one must note that no beneficiary has an absolute entitlement to the trust assets.

• Discretionary trust meaning implies a trust in which the trustee decides which beneficiaries should receive how much income or capital from the trust. The trustee also determines when the beneficiaries should receive the trust assets.
• The beneficiaries do not have a fixed entitlement to the trust’s income or capital.
• A major discretionary trust problem is that its structure does not allow for the distribution of losses.
• Flexibility and eliminating irrelevant decisions are two vital benefits of discretionary trusts.

Discretionary trust meaning implies an irrevocable trust that gives a trustee control and flexibility over how best to utilize the trust assets for the benefit of the beneficiaries. In other words, the trustee can use their discretion to decide when and how to distribute the trust assets to the beneficiary or beneficiaries.

Since fiduciary duty binds the trustees, they cannot utilize the trust assets to fulfill personal requirements despite being the legal owners. They perform all trust transactions in their name and sign every document. Their overriding duty is to act in the best interests of beneficiaries and adhere to the trust deed’s terms.

Besides the trustee, the following individuals play a crucial role within a discretionary trust’s structure:

1. Settlor or Grantor: This is the person who establishes the trust by ‘settling’ for the benefit of the beneficiaries.
2. Appointer: An appointer is a person named in the trust deed; they can appoint and remove a trustee. The appointment or removal may occur if the trustee dies, declares bankruptcy, or becomes incapacitated. Moreover, an appointer may terminate a trustee if the latter breaches their fiduciary duty in any way. Note that the grantor, i.e., the individual who set up the trust, may appoint multiple appointers.
3. Beneficiaries: Beneficiaries are individuals and entities for whose benefit the grantor establishes the trust. Such a trust has an extensive range of beneficiaries that may include other trusts and companies. The grantor can guide the trustee on when to distribute the trust assets. In other words, the settlor can choose the purposes for which the trustee can distribute the assets to the beneficiaries. For example, such purposes can be healthcare, education, etc. Likewise, a grantor can direct a trustee to distribute the trust assets once a beneficiary completes a particular milestone, for example, college graduation.  

Discretionary trusts are subject to the following taxes:

1. Income Tax  

A trustee must pay tax on the earnings of the trust. Income within the trust attracts an additional tax rate of 45%. If the income exceeds the standard rate band (£1,000), the earnings within the band are subject to an introductory tax rate of 20%. Note that a 45% tax credit accompanies any distributed to the beneficiaries. Moreover, some or the entire income may be eligible for a tax reclaim by beneficiaries.

2. Inheritance Tax

Gifts into this type of trust’s arrangement are CLTs or Chargeable Lifetime Transfers if they do not fall within an exempt gift category, meaning they can be instantly subject to inheritance tax.

Suppose such gifts get added to any Chargeable Lifetime Transfer made within the previous seven years, and the overall value is more than the Nil Rate Band (£325,000 for the tax year 2022-23. The excess over the Nil Rate Band will be immediately subject to inheritance tax. If the trustee pays, the charge will be 20%. On the other hand, the rate is 25% if paid by the grantor.

3. Capital Gains Tax

Per legal requirements, trustees may have to pay capital gains tax if they transfer or sell assets on the beneficiaries’ behalf. Similar to individuals, these trusts have a yearly exemption to this tax. However, the maximum limit for this exemption is £6,150 for the tax year 2022-2023. Capital gains exceeding this limit are subject to taxation at 20%.

Let us look at this discretionary trust example to understand the concept better.

Suppose John has an adult daughter with a history of mismanaging her finances. He could set up such a discretionary trust to ensure that his daughter keeps receiving funds from his estate without giving her free reign over the assets. The trustee can use their discretion to determine how much income or capital she should receive and when.  

The benefits of a discretionary trust are as follows:

1. Avoidance Of Probate

When individuals establish such a trust, they transfer ownership of their assets to the trust. They continue to have a right to the assets during their lifetime. However, the assets do not remain a part of their estate. Hence, these assets are not subject to probate. This safeguards such assets from creditors, court fees, and certain taxes. Moreover, the grantor’s family members can receive the trust assets on a timeline that the court system cannot control.

2. No Possibility Of Irrelevant Decisions

Some things in an estate plan may become obsolete or irrelevant for some reason after an individual’s death. The person can eliminate this risk by setting up a discretionary trust. This is because, after the grantor’s death, the trustee can use their discretion to make decisions that benefit all beneficiaries.

3. Offers Flexibility

When drafting a will, individuals usually find it difficult to predict what each family member might require after death. That said, if a person sets up such a trust under their will, the trustee can determine the best way to distribute the estate’s income and capital, depending on the time of the grantor’s death and the circumstances.

4. Non-Distribution Of Losses

The structure of this type of trust does not allow the trustee to distribute losses. Hence, when losses arise, beneficiaries cannot offset them against assessable earnings, for example, dividend income or salary.

The terms discretionary trust, family trust, and unit trust can confuse individuals unfamiliar with these topics. Although these trusts may have some similarities, there are some critical differences between them that one should keep in mind. The table below highlights the distinct characteristics of these three types of trusts.

The discretionary trust problems are as follows:

1. Can Be Expensive

Setting up a trust to safeguard assets can be expensive as the trust might need to pay for legal, accounting, and investment-related services.

2. Loss Of Control

Since the grantor gives broad discretion to the trustee, the former does not have control over the assets. Moreover, the beneficiaries might not depend on their share of the trust assets as the trustee could change alter allocations on a whim.

This article has been a guide to What is Discretionary Trust. We explain its taxation, example, benefits & drawbacks, & comparison with unit trust and family trust. You can learn more about it from the following articles –

• Testamentary Trust
• Last Will And Testament
• Bypass Trust