Client Guide: Discretionary Trusts
The discretionary trust is a very flexible form of trust.
In these trusts the trustees have discretion as to how, when, and for whose benefit to use some or all of the capital and income of the trust fund. Beneficiaries or a class of beneficiaries are named in the trust deed and it is entirely up to the trustees to decide which of the potential beneficiaries is to benefit.
They are useful where the person setting up the trust (known as the settlor) has identified a group of people he wishes to benefit, for example children, but is not certain which of them will need financial help in the future or what help will be required. Sometimes a settlor has a main beneficiary in mind but feels it is inappropriate to put the money in that person's control.
As well as being flexible, discretionary trusts also have the advantage that the trust assets remain outside the beneficiaries’ estates for Inheritance Tax purposes and are disregarded in calculating means tested benefits.
Although discretionary trusts have the merit of being flexible because wide powers are given to the trustees, you will lose control over the ultimate destination of the assets you have put into the trust. You may wish to appoint yourself as a trustee so that you can have some influence over the decisions of the trustees. Alternatively, you can indicate to the trustees how you would like them to exercise their discretion and, although your wishes will not be binding on them, they will often give effect to them.
Discretionary trusts are used to make gifts either during lifetime or on death.
The taxation of a trust is different from the taxation of an individual.
Income and Capital Gains Tax
Any gross income above £1,000 is taxable at the trust tax rate of 45% (2014/2015) except for dividends which are taxable at 37.5% (2014/2015). The gross income up to £1,000 is taxable at 20% (10% for dividends).
If the trustees make a payment of income to a beneficiary who pays tax at less than 45%, the beneficiary can reclaim tax (except in the case of dividends) so that he finishes up suffering no more tax than would have been suffered if the trust assets had been his own.
If the settlor or the settlor's spouse is a possible beneficiary, the income of the trust will be taxable in the hands of the settlor. The same applies to distributions made to the settlor's children under eighteen.
Capital Gains Tax (CGT)
The trustees of discretionary trusts have an annual allowance of £5,450 (2014/2015), compared to an individual's allowance of £10,900. Any gain above this amount is taxable at 28%.
A distribution to a beneficiary is treated as a disposal from a CGT point of view and there may be CGT payable on the distribution of certain assets based on the market value at the time.
In certain circumstances it is possible to "hold over" the gain, which means that the gain of the trustees is transferred to the beneficiary receiving the asset. The gain is then taxed on the beneficiary when the asset is eventually sold.
Inheritance Tax (IHT)
Setting up a trust
The transfer of assets into a discretionary trust is a gift and therefore potentially chargeable to IHT depending on whether the settlor has made other gifts and used his annual allowance of £3,000. In general up to £325,000, the current value of the IHT nil rate band (2014/2015), can be put into a discretionary trust every seven years without incurring a charge to IHT.
Any sum put into a discretionary trust above this amount will incur an immediate IHT charge at 20%. A further 20% may be charged if the settlor dies within seven years.
Certain reliefs can be obtained for shares in a trading company or agricultural property.
Ten yearly charges
Because the trust assets are outside anyone’s estate, HM Revenue & Customs makes a charge to IHT every ten years during the existence of the trust at a maximum rate of 6% on the amount by which the value of the trust fund at the time exceeds the then current nil rate band.
Distribution to beneficiaries or winding up of the trust
There may also be a charge to IHT when the entire trust fund or part of it is distributed to one or more beneficiaries. This will depend on the aggregate value of the distributions made during the last ten years of the trust. The top rate is again 6%.
The trustees have certain duties imposed on them and therefore they need to ensure that the trust is administered properly.
Apart from dealing with income and capital distributions, they need to:
- keep good accounting records,
- record their decisions,
- monitor the assets of the trust,
- ensure that the assets are suitable for the purpose of the trust,
- insure the assets where necessary,
- submit an annual Tax Return to H M Revenue & Customs and pay any tax due.
The type of assets will dictate the amount of administration needed and its cost.
How Blake Morgan can assist the trustees
- By administering the trust for the trustees: completing an annual tax return, reviewing investments and preparing annual trust accounts.
- By advising on the taxation of the trust.
- By advising the trustees in relation to distributions.