Discretionary trusts—what you need to know

A trust is a legal structure for holding assets. They allow a person (the settlor) to place assets such as property, money or personal belongings under the control of trustees, who have a duty to manage the trust’s assets for the benefit of one or more beneficiaries.

Beneficiaries have an interest in a trust, usually meaning they will receive income or be entitled to capital from the trust. They can be individuals, companies, charities or classes of people (for example, 'my children').

Discretionary trusts

With a discretionary trust, beneficiaries can be entitled to varying amounts of the trust capital or income. 

These sums may be set out in the trust deed, which is the document which creates the trust and lays out how it will work.

Alternatively, there may not be fixed rules for how the trust is divided between beneficiaries. The trustees can decide who the beneficiaries are (from a class of potential beneficiaries set out in the trust deed) and what their interest in the trust should be.

They also have discretion as to when trust income or capital is paid to the beneficiaries, if at all. Beneficiaries in a discretionary trust are therefore not automatically entitled to anything from the trust.

A trust itself is not taxed, as it is not a separate legal entity.

Instead, the trustees, beneficiaries and settlor may be liable for different taxes for the trust at various times.

Income arising from trust assets is subject to income tax. Trustees are responsible for paying this.

Trustees may have to pay Capital Gains Tax (CGT) when they sell or transfer assets on behalf of a beneficiary. 

There are special rules Inheritance Tax (IHT) rules for discretionary trusts, known as the relevant property trust regime. According to this, trusts are taxed in three ways, all of which apply above the nil-rate band of £325,000.

• Entry Charge: When assets are given to the trust, they are taxed at 20%. This rises to 40% if the settlor dies within seven years of the transfer.
• Exit Charge: When capital or assets are transferred out of the trust (usually sold or distributed to beneficiaries). This is taxed as a percentage of a maximum of 6%, depending on when within a ten year period the transfer takes place.
• 10 Year Charge: On every 10-year anniversary of the creation of the trust at a maximum of 6%.

Discretionary trusts offer flexibility regarding provision for beneficiaries.

For example, if a beneficiary’s circumstances change, the trustees can take this into account when deciding how much income or capital from the trust to pay to them.

Trustees can also decide who from a class of potential beneficiaries should benefit from the trust. For example, trustees may decide that a trust should benefit only the minor grandchildren of a trust set up for the settlor’s grandchildren.

This flexibility also means that a discretionary trust can also be used to provide for beneficiaries who haven’t been born yet, such as great-grandchildren.

Discretionary trusts are particularly helpful for beneficiaries who cannot manage their own assets, such as children, those who lack capacity or are vulnerable in other ways. A trust can provide for such beneficiaries over time without giving them access to assets which they cannot or do not want to manage.

Discretionary trusts can have tax advantages. For example, by transferring assets, such as a house or part of one, into a trust, the settlor can reduce the value of their estate for IHT purposes.

Trusts are complex. Unless professional trustees are appointed, which will incur costs, lay trustees will have to navigate trust and tax law, and manage the assets of the trust. They will also have to decide how to exercise their discretion as to the beneficiaries of the trust.

Not all potential beneficiaries are guaranteed to benefit. As who benefits and by how much is left up to the discretion of the trustees, some potential beneficiaries who the settlor had intended to benefit may not. A great deal of trust is therefore needed in the trustees appointed in a discretionary trust to ensure that the beneficiaries and their interests are in line with what the settlor would have wanted.

Although trusts can reduce the tax bill for the settlor, they can impose other tax burdens on the trustees and beneficiaries.

If you decide a trust is the best option for you, then next topic to discuss is the gifting element. 

HMRC defines a gift as anything which has value. This can be money, property or personal possessions. A gift can also be a loss of value that occurs when something is transferred (for example, if you sell your house for less than it’s worth to say your children, then the difference in value is seen as a gift).

If a gift is given and the donor (the person making the gift) passes away within seven years, the value of the gift will still form part of the donor’s estate for IHT purposes. The seven years is calculated from the date the gift was given.

There is some relief if the donor passes away within the seven year period. The amount of IHT on gifts reduces the closer the donor gets to the full seven years. Gifts given within three years before the donor’s death are taxed at the full rate of 40% but gifts given three to seven years before the donor’s death are taxed on a sliding scale known as ‘taper relief’.

It is worth noting that taper relief only applies if the total value of gifts made in the seven years before the donor’s death is over the £325,000.00 tax-free threshold.

If the gift was given between:

• three to four years it is taxed at 32%
• four to five years, it is taxed at 24%
• five to six years, it is taxed at 16%
• six to seven years, it is taxed at 8%
• seven or more, it is taxed at 0%

If you have made a gift, there is an important aspect to bear in mind. Gift with a Reservation of Benefit (GROB).

Gifts with a Reservation of Benefits were introduced to stop the avoidance of IHT by making gifts of assets such as a house before their death but continuing to use or benefit from those assets.

For example, a person may give their home to their children but continue to live in the property.

A house would be considered a GROB if:

• an individual disposes of property
• the disposal is by gift
• the disposal is on or after 17 March 1986
• one of the following conditions is met:
  • the recipient of the gift does not receive possession / use of the gift at the beginning of the relevant period
  • at any time in the relevant period the gifted property is not enjoyed to the entire exclusion, or virtually the entire exclusion, of the donor and of any benefit to them by contact of otherwise.

The relevant period in this case is seven years before the donor’s death or where the gift is made within the seven years before death, from the date of the gift to the date of death.

So, what does this mean?

On the date of the transferor’s death if the gift is subject to reservation, the value of that gift will be treated as part of their estate for IHT purposes. The gift will essentially be treated as if it was never made, even if the legal ownership may have changed.

Can you still give your property to a trust and still live there? To avoid a GROB, after giving the legal ownership, you will need to pay rent to the trustees of the trust. The rent must be market rent and be reviewed annually. 

When you make a gift, that gift might be subject to Capital Gains Tax (CGT).

On the disposal of residential property, the tax is charged at either 18% or 28%. There is an annual exemption allowance that can be offset against the gain (as of the 6 April 2023 this has been reduced from £12,300 to £6,000).

However, if you gift your house, you will automatically get a tax relief called Private Residence Relief and will have no tax to pay if the property was your main residence. 

Is placing your property into a trust a good idea? A discretionary trust can be a useful tool to try and mitigate IHT on your estate.

They also offer flexibility as to how the trust is distributed, and can have tax benefits depending on the size of the estate. 

However, can you afford to pay market rent to the trustees if you wish to remain living in the property? Do you want to give up ownership of your home?

Due to their complexity, especially regarding the ongoing tax requirements, and the administrative costs involved in running a trust, gifting your house to a trust is not the right choice for everyone. Advice should be taken before you decide to do this.

Our private client team work with families and individuals, advising on all aspects of private client law, including wills, estate planning, estate administration, trusts and powers of attorney and are well placed to advise you if you have any questions about the topics mentioned in this article.