What are Discretionary Trusts and what taxes are associated with them?
A discretionary trust is a type of trust in which the trustee has the discretion to decide how to distribute the trust assets among the beneficiaries. The trustee is not obligated to distribute the assets in any particular way, and the beneficiaries have no legal right to the trust assets.
Discretionary trusts are used when people want to pass on assets to their beneficiaries in an inheritance tax-efficient manner. They are also used to protect assets from creditors and to provide for family members who may not be able to manage their own finances.
Trustees of a discretionary trust should be individuals who are trustworthy, reliable, and have the ability to make sound decisions. They should also have a good understanding of the trust's purpose and the legal requirements associated with it.
In the UK, a discretionary trust is taxed at the trust rate of 45% on income over £1,000. Any income below £1,000 is taxed at the beneficiary's marginal rate. Capital gains are taxed at 20%. Inheritance tax may also be applicable on each 10 year anniversary of the trust’s original or subsequent settlement.
The decennial charge for a discretionary trust is a tax that is imposed on the trust every 10 years. It is based on the value of the trust's assets and is calculated by the trustee. Generally speaking it is calculated at the rate of 6% of the chargeable assets of the trust in excess of the available nil rate band on the date of settlement.
In the UK, the tax charges that might arise on settling a discretionary trust include inheritance tax, capital gains tax, and income tax.
A chargeable lifetime transfer (CLT) is a transfer of value made by an individual during their lifetime which is subject to Inheritance Tax (IHT). The transfer of value is usually made to another person or trust, including a discretionary trust. It is levied at the rate of 20% of the chargeable transfer of value. Where the donor pays the IHT on the chargeable lifetime transfer, the gross transfer is the amount including the IHT. Eg if an individual with no available nil rate band settles £800,000 of chargeable assets into a discretionary trust and agrees to settle the IHT too, the gross donation would be £1,000,000.
Some assets, such as shares in a privately owned trading company held for more than two years are not chargeable assets for IHT purposes and so can be transferred into a discretionary trust without a chargeable lifetime transfer charge. This can be an effective way of putting considerable funds into trust ahead of a business disposal. You do need to watch for CGT though.
If you have any questions around the efficient use of discretionary trusts please contact our private client team.
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The information in this article is believed to be factually correct at the time of writing and publication, but is not intended to constitute advice. No liability is accepted for any loss howsoever arising as a result of the contents of this article. Specific advice should be sought before entering into, or refraining from entering into any transaction.