When Would I Use a Discretionary Trust?

Discretionary trusts are one of the most potentially useful trust arrangements. Their attractiveness lies in their flexibility; the settlor has significant freedom in setting the terms of the trust.

The unusual aspect of discretionary trusts is the amount of freedom given to the trustees. The assets placed in trust become the property, in title at least, of the trust itself, and the trustees assume responsibility for the management of these assets. In other trust types the ways in which these trustees can act with regard to the assets is very strictly defined; in many cases the trustees are obliged to follow the trust instrument (that is, the document used to establish the trust) to the letter.

In the case of a discretionary trust, however, the trustees must use their discretion to decide which (if any) of the intended beneficiaries should receive income or capital from the trust. They also have the power to decide how much the beneficiaries will receive, and when.

Inheritance Tax

Discretionary trusts are particularly useful for ensuring that inheritance tax (IHT) liabilities are mitigated as far as is possible. As is explained in more detail in an article elsewhere on this site, inheritance tax is only levied on assets in an individual's estate that exceed the Nil-Rate Band, currently set at £325,000. Even then, assets transferred between spouses or civil partners are exempt. However, on the death of the second spouse IHT is charged on the combined estate. As such, if assets are simply transferred to the surviving spouse, considerable IHT exemptions are wasted.

A more efficient course of action is to establish a discretionary trust in the will of the first individual. Under this arrangement, the assets that would otherwise have been transferred to the surviving spouse are instead placed in trust. The spouse is made a beneficiary (or perhaps the sole beneficiary), and trustees are appointed. The beneficiary does not have absolute entitlement to the assets; they cannot demand income or capital as they please. As a result, the assets placed in trust are not treated as part of that individual's estate for tax purposes.

Guidance to Trustees

The settlor should leave a 'letter of wishes' attached to their will. This document contains guidance for the trustees regarding the way in which assets should be disbursed to the beneficiaries. The over-arching theme of this document will normally be that the beneficiary should be sufficiently provided for until their death. As such, the surviving spouse will have access to the deceased individual's assets, but their heirs will avoid a potentially significant IHT bill.

As a result of the relative power given to trustees in a discretionary trust, it is important to think hard about who should be appointed. Depending on the complexity of the settlor's affairs, it is sometimes best to appoint independent commercial executors. This prevents potential confusion if the trustee (who would generally otherwise be a family member or friend) were to die, or become incapable of performing their duties.

It is also important to note that professional advice should always be sought when establishing a discretionary trust, in order to ensure that vital documentation is completed correctly.