Discretionary Trusts are often misunderstood as only being useful for high-net worth individuals. However, whilst they are a useful tool for estate planning and asset protection, they are also useful for those who have complex wishes or wish to prioritise flexibility when considering how they wish to pass their assets to their loved ones.
Discretionary Trusts require a lot of careful planning and this article will explore whether this type of trust could be beneficial for you.
Topics to be answered in this article
What is a Discretionary Trust?
A Discretionary Trust is a legal entity which can be set up during your lifetime; or it can be set up under the terms of your Will. You can decide which assets you want to be held in the Discretionary Trust (e.g. cash, investments, property etc). These assets will be managed by the people that you appoint to be the Trustees.
The Trustees have the power to distribute the income and/or the capital of the trust with their absolute discretion to the beneficiaries (see below for who can be a beneficiary). As the Trustees have discretion with how they distribute assets, a Letter of Wishes would usually be prepared by the Settlor, which provides direction and guidance to the Trustees. For example, a beneficiary may be in the process of getting divorced and the guidance may therefore suggest that assets should not be distributed to them until the divorce has been finalised in order to protect the asset from any financial settlements.
The Letter of Wishes can provide for changes in the beneficiary’s circumstances and ask the trustees to reconsider how assets are distributed in accordance with personal situations at the time.
What are the benefits of a Discretionary Trust?
Whilst there are many benefits to a discretionary trust, there are three main ones that you could benefit from; flexibility, protection, and tax implications.
1. Flexibility
As mentioned above, one of the main benefits of a Discretionary Trust is the flexibility it can provide your trustees. This could be beneficial if the intended beneficiaries are minors at the time the trust is set up. Or, the beneficiaries may be adults but they are vulnerable and are not in a position to handle such assets, e.g. if they are battling addiction.
2. Protection
Additionally, whilst assets are held in the trust, the assets are protected. This is favourable if a beneficiary receives means-tested benefits, and an outright inheritance would negatively affect their financial position.
3. Tax implications
A discretionary trust also allows your trustees to consider the tax implications of distributing assets at that period of time. Whilst we have not seen changes to inheritance tax allowances for a long time, there has recently been room for speculation that everything we currently know about inheritance tax is set to change. But, it is not only inheritance tax the trustees would look to consider, they would also look at the capital gains tax and income tax implications on their potential decisions and they would have the discretion to decide the best way forward.
When might you use a Discretionary Trust?
Beneficiary doesn’t have the mental capacity: Your intended beneficiary does not have the mental capacity to manage an outright inheritance and they will need someone to help manage their finances. The trustees could look to invest the funds for their benefit and manage the income they receive, as well as ensuring that any benefits they receive are not affected.
Protect assets: It would be beneficial to protect your assets from the intended beneficiaries for a period of time. E.g. if your child was going through a divorce, the assets in the trust would not belong to them so the value of the assets could not be included in any financial settlements. Once the divorce has been finalised, the trustees could then consider distributing the assets to them.
Reduce inheritance tax: Depending on the value of your estate at the time the trust is set up, putting assets into a discretionary trust during your lifetime could help to reduce the total amount of inheritance tax when you die.
Who can be a beneficiary?
You can name anyone as a beneficiary of your Discretionary Trust. Common examples include:
- Your spouse/partner
- Classes of people (e.g, children and step-children and their descendants, to include future descendants who have not been born yet)
- Charities
- Other organisations or clubs.
What is a trustee and what powers do they have?
Trustees are the people you appoint to manage the assets and the trust on your behalf. They should be the people you trust the most and know you can rely on to act in the best interest of the beneficiaries.
The powers they have will be outlined in the instrument used to set up the trust, i.e. the Trust Deed or the Will. It is also recommended that a Letter of Wishes is provided to offer the trustees with guidance on how you want them to act and your requests.
An example on how you may wish them to act could include taking financial advice from a particular accountant who has excellent knowledge on your assets. Another example could be to refrain from distributing money to your children until they are of a certain age or they need financial assistance with tuition fees or driving lessons etc.
What are the downsides of a Discretionary Trust?
Whilst the mechanics of a Discretionary Trust can all appear attractive, there are of course some disadvantages to be aware of.
The first one to be aware of is the administration involved, including registering the trust with the Trust Registration Service. Additionally, the trustees will be responsible for record keeping and submitting tax returns (if applicable) and some people may find this overwhelming. Of course, they do have the option of obtaining assistance from a professional, but this will inevitably increase the ongoing administration fees.
There is also the risk that you could lose your Residence Nil Rate Band. The Residence Nil Rate Band is an additional inheritance tax allowance (£175,000) that you can claim if you are passing your property to a child or grandchild on your death. For a married couple, this could be an additional allowance of £350,000 on the second of your deaths. This risk could however be mitigated if the property is appointed out of the trust within 2 years from the date of death.
Depending on your objectives and reasons for setting up the Discretionary Trust, there could be other options. For example, if your main objective is asset protection, then instead you could perhaps consider setting up a Life Interest Trust in your Will. If your main objective is inheritance tax planning, then it could be helpful to discuss alternative strategies, e.g. lifetime gifting.
How can Goughs help?
If you are considering setting up a Discretionary Trust or would like to obtain more advice about whether it is the right decision for you, Goughs are here to help you navigate the different options and find the best way forward. Alternatively, if you have been appointed as a Trustee and are looking for guidance, we are here to support you.
