How Do Discretionary Trusts Work?
Discretionary Trusts are a crucial but often misunderstood aspect of estate planning. In this guide, our experts explain exactly how they work and for whom they are best suited.
Trusts have long been a useful way to manage your wealth and ensure that it is distributed according to your wishes. A key instrument in estate planning, Discretionary Trusts offer many opportunities but come with their own set of complexities and responsibilities that are vital to understand.
Whether you are considering asset protection, future estate planning, or Inheritance Tax mitigation, or simply wish to broaden your legal knowledge, this comprehensive guide should answer any question you may have in relation to Discretionary Trusts.
Our experts can explain how to set up a Discretionary Trust, how they function, and discuss the key considerations and tax implications for anyone contemplating this as part of their estate planning.
If you have any questions we have not answered regarding Discretionary Trusts, our expert Wills, Trusts & Probate solicitors are happy to speak to you regarding your query and provide the legal services you need. You can contact us by completing the enquiry form below or by calling 0151 666 9090.
What Is a Trust?
Before diving into the specifics of Discretionary Trusts, let us clarify what a trust is. A trust is a legal arrangement where one or more people, known as trustees, hold and manage assets for the benefit of others, who are known as beneficiaries. The assets within a trust can be diverse, including but not limited to, property, investments, and cash.
Trusts are governed by a legal document known as the “trust deed” which outlines the rules under which the trust must operate. It specifies the terms of the trust, identifies the trustees and beneficiaries, and provides guidance on the distribution of assets.
Trusts are often set up for various purposes including wealth management, asset protection, tax planning, and to provide for vulnerable beneficiaries who may not be capable of managing their own finances.
Given their flexible nature and ability to cater to different needs, trusts can be very important in estate planning and wealth management, offering both control and tax efficiency in how your estate is distributed to future generations after your death.
How Do Discretionary Trusts Work?
Discretionary Trusts are a specialised type of trust arrangement offering the trustees a greater degree of flexibility and control over the distribution of trust assets. Unlike other trusts where beneficiaries have fixed entitlements, Discretionary Trusts allow trustees to decide who receives what, when, and how often from the trust fund. The deed will specify the potential beneficiaries, but it is up to the trustee or trustees to determine when and how much of the estate is shared.
How The Trust Works
The Discretionary Trust is usually established by a legal document called the “trust deed”, and is often accompanied by a “letter of wishes”. The deed sets the framework for the trust and outlines the trustees' powers and responsibilities. The letter of wishes, while not legally binding, provides the trustees with guidance on how the settlor (the person who establishes the trust) wishes for the trust assets to be managed and distributed.
As well as their responsibility to protect assets and maintain the value of the assets at the highest possible level, trustees must understand the tax rules that apply when they make decisions, and pay tax where it is owed - for example, if trust assets are sold and there is a need to pay Capital Gains Tax, trustees will be responsible for this.
Finally, every trustee must act in the best interests of the beneficiaries. As such, there are strict responsibilities for trustees to uphold and it is vital to choose the right person or people to act in this capacity when you set up a Discretionary Trust.
Beneficiaries and Payments
In a Discretionary Trust, beneficiaries do not have a fixed or automatic entitlement to the trust's income or capital. Instead, they are part of a “class of beneficiaries”, such as children or grandchildren of the settlor. The trustees have the discretion to make payments of income or capital to any beneficiary within this class. They can also decide the timing and frequency of these payments. This enables the trustees to respond flexibly to beneficiaries' changing circumstances and needs over time.
Accumulation of Assets
Trustees can choose not to distribute income, instead opting to add it to the trust's capital. This is known as “accumulating” the income, which can then be invested to generate further income for the trust. However, the rules regarding the accumulation period can vary and may be limited in older trusts. This will also have tax implications, as if the trust income is subject to income tax, trustees may need to make these payments. In turn, this can affect the value of the trust and have consequences that are vital to consider.
Acting in the Best Interests of Beneficiaries
While the trustees have broad powers, their decisions must always be in the best interests of the beneficiaries and compliant with the trust deed and relevant laws. Decisions regarding payments are often made in trustee meetings, and it is advisable to keep a written record of the reasoning behind each decision.
Generally speaking, Discretionary Trusts provide a flexible vehicle for managing and distributing assets to beneficiaries, while allowing for tailored solutions that can adapt to changing needs and circumstances. They can also help to lower the tax rate that your beneficiaries must pay on your estate, but it is important to work with an expert when you set up a discretionary trust to fully account for the tax implications that will apply.
Why Create a Discretionary Trust?
The decision to establish a Discretionary Trust (as opposed to a fixed or "normal" trust) often boils down to the level of flexibility and control required by the settlor (the person who is creating the trust).
Trustees have the power to determine how, when, and to whom a discretionary trust's assets should be distributed, which can be invaluable when the needs of beneficiaries are likely to change over time. This could be especially useful in families with a disabled dependent or where there are concerns about the financial responsibility of a potential beneficiary. This can also enable the settlor to name beneficiaries who do not yet exist - for example, future grandchildren who are not yet born when the trust is created.
Fixed trusts, by contrast, require that assets be distributed in a predetermined way, which may not allow for adjustments based on evolving circumstances.
Discretionary Trusts can also offer more efficient tax planning opportunities. For instance, trustees can distribute income or capital gains to beneficiaries who are in a lower tax bracket to minimise overall tax liability. While fixed trusts also offer tax benefits, they are generally not as flexible in this regard.
The Roles Involved in a Discretionary Trust
Understanding the roles involved in a Discretionary Trust is crucial to its successful operation. Below, we explain the key roles involved in a Discretionary Trust and what each entails.
The settlor is the person who establishes the trust by transferring assets into it. The settlor's primary role is to provide the trust property and assets. They will set out the terms of the trust, identify beneficiaries and outline how it should be administered.
They generally have limited involvement in the trust's ongoing management after it has been set up. Often, a trust's creation is tied to the settlor's will, meaning that some of the biggest decisions in the management of the trust may happen after their death.
Trustees play arguably the most pivotal role in a Discretionary Trust. They are responsible for the management and administration of the trust assets, and their duties include:
- Deciding when, how, and to whom the dividend income and/or capital should be distributed
- Investing the trust assets responsibly
- Keeping accurate records and accounts
- Ensuring compliance with relevant tax obligations
Trustees must act impartially, in the best interests of the beneficiaries, and in accordance with both the trust deed and the law. Some settlers choose to pay professional trustees to carry out these responsibilities and ensure the influence of a neutral party in the decision-making process.
In a Discretionary Trust, beneficiaries are the individuals or entities that may receive income, dividends or assets from the trust, but they do not have an automatic right to any income or capital.
Trustees have the discretion to determine the amount and timing of any distributions. Beneficiaries could be family members, friends, or even charitable organisations.
Advantages and Disadvantages of Discretionary Trusts
Like any financial or estate planning tool, Discretionary Trusts have their pros and cons. Before deciding to establish one, it is essential to understand these aspects fully.
- Flexibility: One of the primary benefits of a Discretionary Trust is the flexibility it offers. Trustees have the discretion to manage the trust’s assets and distribute them as they see fit, guided by the settlor's wishes but not strictly bound by them.
- Asset Protection: Discretionary Trusts can provide a level of protection against creditors and prevent legal actions against beneficiaries, as the assets are held in the trust’s name.
- Tax Planning: The trust structure also allows for various potential tax advantages, including reducing Inheritance Tax liability.
- Succession Planning: A well-structured Discretionary Trust can facilitate a smoother wealth transfer, enabling a family to benefit from the assets over a long period without the need for multiple wills and probate processes.
- Control: Especially in families with young or financially inexperienced members, a Discretionary Trust can ensure that the assets are managed prudently.
- Confidentiality: Unlike wills, which become public documents once they are probated, the details of a Discretionary Trust are generally not publicly disclosed, offering greater privacy.
- Complexity: Discretionary Trusts can be complex to set up and require ongoing management from a legal expert.
- Potential for Conflict: With greater discretion comes the potential for disagreements or conflicts among beneficiaries, especially if they feel the distributions are not fair. Trustees might also struggle to reach agreements on the decisions they need to make.
- Regulations and Taxes: Discretionary Trusts have to comply with a range of laws and regulations, including regular reporting and tax obligations. Failure to comply can result in penalties.
- Limited Access for Beneficiaries: Since beneficiaries do not have an automatic entitlement to the trust's assets, those who are in immediate need might find it difficult to access funds unless the trustees agree to distribute them.
- Irrevocability: Depending on how the trust is structured, unwinding a Discretionary Trust can be a complicated and expensive process.
We recommend speaking to an expert Trusts Solicitor before deciding whether a Discretionary Trust is the right solution for your specific needs.
How can Percy Hughes & Roberts help?
Navigating the intricacies of estate planning, wealth management, and meeting tax obligations can often seem complex, but they are essential tasks that have long-term implications for you and your loved ones. A Discretionary Trust, with its blend of flexibility, asset protection, and potential tax benefits, can be an invaluable tool in your estate-planning toolkit.
We recommend that anyone considering establishing a Discretionary Trust consult with legal experts to fully understand the implications and obligations involved. At Percy Hughes & Roberts, our specialists in trusts and estates are well-equipped to guide you through the process, ensuring that you make informed decisions that align with your long-term goals and the needs of your beneficiaries.
If you require legal advice in relation to setting up a Discretionary Trust or protecting your estate, or you need assistance with anything else to do with wills, trusts and probate, Percy Hughes & Roberts can help. If you would like to contact one of our expert wills, trusts and probate solicitors you can do so by calling 0151 666 9090 or by completing the “Get in touch” form on this site.