Key considerations for discretionary trusts

What is a discretionary trust and how does it work?

A discretionary trust is a type of trust where the trustees have discretionary powers (which may be broad or limited by the trust deed) over how and when to distribute the trust's assets among a defined class of beneficiaries.

Unlike fixed trusts, beneficiaries of a discretionary trust have no fixed entitlement to the trust property or income - they only have a hope or chance of receiving a benefit, known legally as a 'mere expectancy.' This flexibility makes discretionary trusts particularly useful for tax planning and protecting family wealth, as beneficiaries cannot claim specific rights to trust property, and the trust assets generally fall outside their estates for tax and bankruptcy purposes.

The objectives are often long term and with an emphasis on flexibility. Careful choice of trustees is hugely important in setting up any type of trust but even more so with a discretionary trust, where trustees may be given wide powers.

We find that most clients who want to create a discretionary trust do so because of concerns about family issues. They are seeking to preserve value for beneficiaries and possible future generations. Reasons commonly include :

• Family business succession concerns - There is a family business and there are concerns about how beneficiaries would run the business. The availability of Business Property Relief (“BPR”) can often be factor as well but specific advice should be sought in relation to BPR aspects of discretionary trusts.

• Concerns about financial irresponsibility - One or more of the beneficiaries has an unstable lifestyle, perhaps with addictions, mental health problems or a bad track record of dealing with money.

• Providing for a beneficiary with a disability - One or more of the beneficiaries has disabilities which mean they need long term care and are perhaps unable to make decisions for themselves.

• Protecting future generations - You specifically want to ensure that your legacy benefits grandchildren, whether these are living or not yet born.

• Protecting capital - You may want to protect the capital value of your assets. The trust can provide that beneficiaries will only receive income under the trust, with income generation being the prime objective for the trustees to use their discretion to achieve

Are discretionary trusts tax efficient?

Tax is almost always a prime consideration.

Discretionary trusts are less tax advantageous now primarily because of the introduction of the transferable nil rate band between spouses in 2007 (meaning couples can combine their inheritance tax allowances without needing a trust) and changes to trust taxation including periodic charges every 10 years and exit charges when assets leave the trust.

Anti-avoidance legislation applies to family trusts where the settlor retains any interest in the assets and the assets will be included in the estate for Inheritance Tax (IHT) purposes. Family trusts are also charged tax of up to 6% of the value of the assets every 10 years and upon exit.

Set up in will or during lifetime?

A lifetime discretionary trust is often created when someone wants to start tax planning early, retain some control over assets while alive, or protect assets for vulnerable family members during their lifetime. These can also help with immediate asset protection or business succession planning.

Will trusts (created on death) are more common when the main concern is managing inheritance after death, particularly in complex family situations like second marriages.