Wealth Planning

Discretionary Trust


What is a discretionary trust?

In a discretionary trust, the ‘trustees’ are the legal owners of any assets – known as ‘property’ – held in the trust. They are responsible for running the trust for the benefit of the beneficiaries.

The trustees have ‘discretion’ about how to use the income received by the trust. They may also have discretion about how to distribute the trust’s capital. In many such trusts the trustees can also accumulate income – see the section below on accumulation trusts.

Trustees may decide:

  • how much is paid out
  • to which beneficiary or class of beneficiaries payments are made
  • how often the payments are made
  • what, if any, conditions to impose on the recipients

Under the terms of the deed that creates the trust, there may be situations when the trustees are required to use income for the benefit of particular beneficiaries. However, they may still retain discretion about how and when to pay. The extent of the trustees’ discretion depends on the terms of the trust deed.

Sometimes the person who sets up the trust – the settlor – will use a discretionary trust to set aside capital for:

  • a future need that may not yet be known, for example a grandchild that may require more financial assistance than other beneficiaries at some point in their life
  • beneficiaries who are perhaps not capable or responsible enough to deal with money by themselves

Example

Mina puts money into trust, to be held in trust for twenty years for the benefit of her two ten-year-old grandchildren, Azra and Jaspal. The trustees can decide how to invest or use the money and any interest it earns to benefit the grandchildren. So, when the children are young, the trustees might decide to pay for piano lessons for them. As they get older, the trustees might pay towards a wedding.

Accumulation trusts

Accumulation trusts are a type of trust where the trustees can ‘accumulate’ income within the trust.

They will often do so until the beneficiary becomes legally entitled to the trust property or the income arising from this property. Income that has been accumulated becomes part of the capital of the trust. In many such trusts the trustees can also pay income at their discretion.

Accumulation trusts should not be confused with ‘accumulation and maintenance trusts’. The latter is a type of trust that received favourable Inheritance Tax treatment. The Finance Act 2006 ended this favourable treatment and made provisions for accumulation and maintenance trusts to become either ‘18 to 25 trusts’ or to be moved into the new ‘relevant property’ regime.

Discretionary or accumulation trusts and Income Tax

Trustees are responsible for declaring and paying Income Tax on income received by the trust. They do this on a Trust and Estate Tax Return each year.

In both discretionary trusts and accumulation trusts income is taxable at the special trust rates, apart from the first £1,000 of trust income, which is known as the ‘standard rate band’. Income that falls within the standard rate band that would otherwise be taxed at the higher rates (37.5 per cent for dividend income and 45 per cent for other income) is taxed at lower rates, depending on the nature of the income.

(Please note, if the settlor has more than one trust, the £1000 standard rate band is divided by the number of trusts the settlor has. If the settlor has more than five trusts, the standard rate band is £200 for each trust.)

Special rules apply to trusts with vulnerable beneficiaries – see the section on vulnerable beneficiaries below.

Some items that are capital in trust law are treated as income for tax purposes when received by trusts. They are taxed at the trust rate (45 per cent) or the dividend trust rate (37.5 per cent), depending on the type of capital.

Discretionary income payments to beneficiaries

When trustees make a discretionary payment of income it carries a tax credit at the trust rate (currently 45 per cent). This means it is treated in the hands of the beneficiary as if Income Tax has been already paid at 45 per cent. The beneficiary could claim some or all of the tax back if they are a higher rate, basic rate or non-taxpayer.

Trustees of a discretionary trust – or an accumulation trust where they also have the power to make discretionary payments – need to make sure that they have paid enough tax to cover the tax credit given to the beneficiary. They do this using a mechanism called the ‘tax pool’, which keeps a record of all discretionary income payments made by the trustees, and the tax the trustees have paid at the special trust rates.

Discretionary or accumulation trusts and Capital Gains Tax

Capital Gains Tax is a tax payable on ‘gains’ (profits) made from the sale or transfer of assets such as shares, property or possessions. It is chargeable in the same way on all trusts. Trustees are liable to Capital Gains Tax on any chargeable gains above an amount set each year called the ‘annual exempt amount’.

Beneficiaries are not taxed on any trust gains and do not get credit for tax paid by the trustees.

Discretionary or accumulation trusts and Inheritance Tax

There may be an Inheritance Tax charge when:

  • assets (money or property) are put into a discretionary trust
  • a discretionary trust reaches a ten-year anniversary
  • assets are distributed from a discretionary trust or the trust ceases

It is worth noting that the Inheritance Tax regime sometimes uses its own classification for trusts. Discretionary trusts may fall within what are known as ‘relevant property’ trusts.

Discretionary or accumulation trusts with vulnerable beneficiaries

A discretionary or an accumulation trust may be used to help a ‘vulnerable beneficiary’. A vulnerable beneficiary is someone who is:

  • mentally or physically disabled
  • a child below the age of 18 who has lost a parent through death

A trust set up for the benefit of a vulnerable beneficiary may qualify for special tax treatment.

he power to make discretionary payments – need to make sure that they have paid enough tax to cover the tax credit given to the beneficiary. They do this using a mechanism called the ‘tax pool’, which keeps a record of all discretionary income payments made by the trustees, and the tax the trustees have paid at the special trust rates.

Discretionary or accumulation trusts and Capital Gains Tax

Capital Gains Tax is a tax payable on ‘gains’ (profits) made from the sale or transfer of assets such as shares, property or possessions. It is chargeable in the same way on all trusts. Trustees are liable to Capital Gains Tax on any chargeable gains above an amount set each year called the ‘annual exempt amount’.

Beneficiaries are not taxed on any trust gains and do not get credit for tax paid by the trustees.

Discretionary or accumulation trusts and Inheritance Tax

There may be an Inheritance Tax charge when:

  • assets (money or property) are put into a discretionary trust
  • a discretionary trust reaches a ten-year anniversary
  • assets are distributed from a discretionary trust or the trust ceases

It is worth noting that the Inheritance Tax regime sometimes uses its own classification for trusts. Discretionary trusts may fall within what are known as ‘relevant property’ trusts.

Discretionary or accumulation trusts with vulnerable beneficiaries

A discretionary or an accumulation trust may be used to help a ‘vulnerable beneficiary’. A vulnerable beneficiary is someone who is:

  • mentally or physically disabled
  • a child below the age of 18 who has lost a parent through death

A trust set up for the benefit of a vulnerable beneficiary may qualify for special tax treatment.

Our Wealth Planning Team

Michael Culver
I am a Partner and head of the Wealth and Estate Planning team at Bolt Burdon. Read More
T: 020 7288 4713
Helen Beach
I am a Partner in the Wealth and Estate Planning Team. Read More
T: 020 7288 4783
John Nettleship
I am a Senior Solicitor in the Wealth & Estate Planning Team Read More
T: 020 7288 4788
Tanya Lloyd
I am an Associate in the Wealth and Estate Planning Team. Read More
T: 020 7288 4771
Pamela Jarvis
I am a Senior Paralegal in the Wealth and Estate Planning team, and I work primarily in our Court of Protection team, assisting elderly and vulnerable clients. Read More
T: 0207 288 4764
Sam Hoskins
I’m a paralegal within the Wealth and Estate planning team. Read More
Vaishali Kapadia
I am a Senior Solicitor in our Wealth and Estate Planning Team. Read More
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