What is a discretionary trust and when should you set one up?

Discretionary trusts offer flexibility and control in estate planning. Clarissa Landcastle, an Associate in our Trusts and Estates Administration team, explains how they work and when to use them.

When it comes to passing on wealth or protecting assets, many people are familiar with the idea of trusts. There are a number of different types of trust and one of the most versatile options is a discretionary trust, which gives trustees the power to decide how and when assets are distributed to beneficiaries. This flexibility makes discretionary trusts incredibly useful in a wide range of situations, from providing for young or vulnerable people to safeguarding assets for future generations.

This article explores what discretionary trusts are, how they work, and when they might be the right solution for your estate planning goals.

What is a discretionary trust?

A discretionary trust is a legal arrangement where a person, known as the settlor, transfers assets into a trust for the benefit of one or more individuals, known as the beneficiaries. Instead of fixed entitlements, the trustees are given discretion over how and when to distribute income and capital and to which of the beneficiaries. The trust can hold cash, investments, property, or other assets, and the trustees manage these on behalf of the beneficiaries.

Unlike other types of trust where the beneficiaries have a right to income or capital, beneficiaries of a discretionary trust do not have an automatic entitlement to the trust assets. This allows trustees to take into account the changing needs or circumstances of the beneficiaries when deciding how to manage the trust assets.

Who is involved in a discretionary trust?

There are three key parties:

1. The settlor – the person who creates the trust and transfers assets into it;
2. The trustees – the individuals or professionals responsible for managing the trust and making decisions about distributions; and
3. The beneficiaries – the people, classes of people or organisations, who may benefit from the trust at the trustees’ discretion.

Often, the settlor will write a letter of wishes to guide the trustees. This is not legally binding, but it provides context around the settlor’s intentions and can help the trustees in their decision making.

How does a discretionary trust work?

Once assets are transferred into a discretionary trust, the legal ownership passes to the trustees. From that point on, the trustees are responsible for managing the trust assets in line with the trust deed, trust law, and any guidance from the settlor.

Trustees have complete discretion over:

• Whether to make payments to beneficiaries;
• Which beneficiaries to benefit;
• How much to distribute and when; and
• Whether to retain or reinvest trust assets.

This structure makes discretionary trusts ideal when it is important to retain flexibility, for example, if the financial needs of beneficiaries are uncertain or likely to change over time.

Why use a discretionary trust?

There are several reasons why someone might choose to set up a discretionary trust. These include:

1. Flexibility for changing circumstances: Life is unpredictable, and discretionary trusts allow trustees to respond to changes such as a beneficiary experiencing financial hardship, marriage breakdown or health issues.
2. Protecting vulnerable beneficiaries: Where a beneficiary lacks capacity or might be receiving means tested benefits, a discretionary trust can ensure that they are supported without their entitlement being affected.
3. Controlling access to wealth: Discretionary trusts are a useful tool for managing wealth for young or financially inexperienced beneficiaries, allowing trustees to make decisions about when, and whether, they receive funds.
4. Asset protection: Assets held in a trust are generally protected from claims from creditors or in divorce proceedings, which can be particularly important in succession planning.
5. Succession planning for blended families: Discretionary trusts can be structured to benefit children from previous relationships while also providing for the current spouse or partner, helping to manage complex family dynamics.

When should you consider setting up a discretionary trust?

Discretionary trusts can be useful in the following situations:

• You want to leave assets to children or grandchildren but want to retain control over when and how they receive them.
• You have beneficiaries who may not be financial responsible.
• You want to provide for someone who receives means tested benefits.
• You are concerned about potential future divorce or creditor claims.
• You want to make a lifetime gift but are not yet sure who should benefit and in what shares.
• You run a business and want to pass shares down the generations in a controlled way.

Discretionary trusts can be set up during your lifetime or written into your will to take effect after your death. There are different tax and administrative implications for each.

How we support clients with discretionary trusts

We regularly advise clients on the creation and use of discretionary trusts, tailored to their individual needs and circumstances. In one case, we worked closely with a family in creating a lifetime discretionary trust to hold company shareholdings, following a recommendation from their accountant. The trust provided flexibility in distributing income among family members whilst preserving family ownership of the business. We have also prepared wills incorporating discretionary trusts for vulnerable beneficiaries, to take effect on the client’s death. In several of these cases, we continue to assist with the ongoing administration of the trusts to ensure the beneficiaries are cared for as intended.

Clarissa Landcastle, Associate in our Trusts and Estates Administration team, said:

“In my experience, discretionary trusts can provide a powerful and flexible solution for clients with very different needs. I’ve helped families use them to preserve business assets and supported individuals planning for vulnerable loved ones. Each case is unique, but the common thread is the peace of mind a well-structured trust can bring.”

Tax on discretionary trusts

Discretionary trusts come with their own tax considerations, which is a factor in deciding whether a discretionary trust is the right option. The following is brief overview of the taxation regime:

Inheritance Tax (IHT)

When you set up a discretionary trust in your lifetime it is usually treated as a chargeable lifetime transfer. If the value exceeds your available nil rate band an immediate 20% IHT charge applies.

Discretionary trusts are also subject to 10 year anniversary charges and exit charges on assets distributed out of the trust. These both depend on the value of the trust and available nil rate band at the time of the anniversary or exit.

Capital Gains Tax (CGT)

Trustees have an annual exemption at the rate applicable to trusts (currently £1500) and pay CGT at the higher rate.

Income tax

Income retained in a discretionary trust is taxed at the trust rates (currently 39.35% on dividend income and 45% on all other income). However, if income is distributed to beneficiaries they may be able to claim a tax credit.

Proper advice can help you plan around these tax charges and use exemptions or reliefs where available.

 How do I set up a discretionary trust?

You will need:

• A well drafted trust deed, setting out the terms of the trust and powers of the trustees;
• A clear list of beneficiaries or class of beneficiaries; and
• Carefully chosen trustees who understand their duties and responsibilities.

You should also consider writing a letter of wishes to guide the trustees, without binding their decisions.

Professional advice is highly recommended to ensure the trust is properly structured and administered, and to avoid unexpected tax consequences.

Is a discretionary trust always the right choice?

If you are looking to make a straightforward gift, or you want someone to have a guaranteed income or right to capital, a different type of trust, or perhaps no trust at all, might be the best option.

Read “Putting Trust In Trusts And Estate Planning” for further information about the type of trusts available, by Alix Langrognat.

Is it time to explore your options?

Discretionary trusts can be a useful way for someone looking to protect their assets, provide for loved ones or plan for the future with greater control and flexibility.