An introduction to discretionary trusts

A trust is a legal arrangement used to protect assets, such as land, buildings or money for the benefit of the “beneficiaries” to the trust. Such assets are known as “trust property”. When a trust is created “trustees” are appointed. The trustees are legally responsible for the assets held in the trust and are required to manage the trust and carry out the wishes of the person whose assets were placed into trust. The person whose assets were placed into trust is known as the “settlor”.

There are a number of different types of trusts, one of which is a known as a “discretionary trust”. When a discretionary trust is created the settlor gives the trustees the “discretion” as to how to use the income generated by the trust, and sometimes the capital. Sometimes a discretionary trust will give the trustees the power to add the income to the capital. This power is known as the power to “accumulate” income.

What powers do the trustees of a discretionary trust have?

A trust is created by a will or a legal document known as a “deed of trust” (sometimes called a “trust deed”). The powers of the trustees will depend upon what powers they were granted under the will or deed of trust. Quite often a settlor will also leave a “letter of wishes” setting out how they would like the trustees to exercise their powers.

The trustees of a discretionary trust may, for example, be granted the power to decide how much income or capital is paid out, to whom and when.

When are discretionary trusts used?

Discretionary trusts can be used as a means of mitigating, as far as is possible, an estate’s liability to Inheritance Tax.

They can also be used where a testator’s wish is for there to be flexibility as to how his or her income or capital is used or where a beneficiary is not capable or responsible enough to look after their own financial affairs. The flexibility of a discretionary trust may, for example, enable the trustees to provide financial assistance to a beneficiary at a point in their life when they need it the most such as to fund their education.

Who should be appointed as the trustees under a discretionary trust?

Since the trustees under a discretionary trust have wide powers it is important to give careful consideration as to who should be appointed as the trustees. If an estate is of high value or is complex it may be sensible to appoint an independent trustee, for example a solicitor.

What are the tax implications of a discretionary trust?

Income Tax

Income generated by a discretionary trust is subject to Income Tax. It is the responsibility of the trustees to declare and pay any Income Tax due. There are special rates of Income Tax for trusts and these apply to discretionary trusts.

Under the special rates for trusts the Income Tax payable depends upon how much income is generated and where the income comes from.

The rates for the tax year 2010/ 2011 are as follows:

Where the income is £1,000 or less and comes from rent, trading and/ or savings the rate of tax is 20% (this is known as the “basic rate”);

Where the income is £1,000 or less and comes from UK dividends (for example income from stocks and shares) the rate of tax is 10% (this is known as the “dividend ordinary rate”);

Where the income is over £1,000 and comes from dividends and distributions the rate of tax is 42.5% (this is known as the “dividend trust rate”);

Where there is other income over £1,000 the rate of tax is 50% (this is known as the “trust rate”).

The first £1,000 of income is referred to as the “standard rate band”. If the settlor created more than one trust, the standard rate band is divided by the number of trusts the settlor created unless more than 5 trusts were created, in which case the standard rate band is £200 per trust.

In some circumstances capital is treated as income for Income Tax purposes.

Any discretionary payments of income made to the beneficiaries of the trust are taxed at the trust rate of 50%. However, if a beneficiary is a non-tax payer or pays Income Tax at the 20 or 40% rate they may be able to claim some or all of the tax back.

Special rules apply where a beneficiary is under the age of 18 and has lost a parent and where a beneficiary is mentally or physically disabled. Such persons are referred to as “vulnerable beneficiaries”.

Capital Gains Tax

Where trust property is sold, given away or disposed of and such property has gone up in value since being put into trust, Capital Gains Tax may be payable.

It is the responsibility of the trustees to declare and pay any Capital Gains Tax due.

Beneficiaries are not taxed on any trust gains and cannot get credit for any Capital Gains Tax paid by the trustees.

Inheritance Tax

Inheritance Tax may be payable when assets are placed into a discretionary trust or when the discretionary trust reaches a 10 year anniversary. Inheritance Tax may also be payable if assets are taken out of a discretionary trust or if the discretionary trust comes to an end.