How is a Discretionary Trust Taxed?

Discretionary trusts can be highly useful estate planning tools. The effective use of such a trust can ensure that Nil-Rate Band inheritance tax exemptions are used to their full effect; as such they can represent a significant tax saving for an individual’s heirs.

Details regarding the proper use of discretionary trusts are available elsewhere on this site. In basic terms, however, under such an arrangement assets are transferred by the settlor into trust, and the trustees assume the legal title to those assets.

The trustees can then choose when and how much to pay out to each of the beneficiaries; none of the beneficiaries has an absolute right to a payment. The trustees may be guided by a ‘letter of wishes’ provided by the settlor, but this is not a legally binding document.

Income & Capital Gains

The tax treatment of discretionary trusts is comparatively complicated. In the first instance, it is important to remember that there is no tax implication for the settlor. As they give up ownership of their assets, they will not be required to pay income or Capital Gains tax on the trust.

Conversely, as the trustees take on the legal title they will be required to pay income and Capital Gains tax in exactly the same way as they would if they owned the assets as individuals. Income and capital gains are charged at a flat rate of 40%, although reasonable management expenses are deducted before tax. Trustees, like individuals, are entitled to an annual exemption for capital gains, but the exemption available to trustees is considerably lower.

There are also tax implications for the beneficiaries when they eventually receive payment from the trust. Beneficiaries will be required to pay income tax on these payments at their regular rate. However, the tax already paid by trustees will be deducted from this liability. In circumstances in which the trustees have paid more tax than that for which the beneficiary is liable, a rebate will be given to the beneficiary.

Inheritance Tax

It is important to note that, as well as the liabilities listed above, discretionary trusts also have an inheritance tax charge levied every ten years. In most cases, Nil-Rate Band discretionary trusts will escape this charge, but they will otherwise be taxed at a rate of around 6% of the total value of the assets held in trust. Inheritance tax is also charged when assets are disbursed. This charge is not levied at a set rate, but rather depends on how long the assets have been in trust since the last ten year charge; the rate at which they were last subject to inheritance tax; and the value of the assets.

The tax schedule that applies to discretionary trusts is, as can be seen, fairly complex. While these trusts are potentially vital for mitigating an inheritance tax liability, it is important to seek independent financial advice when establishing one. If the trust is established or funded inefficiently it may well be that the trust itself ends up presenting an inheritance tax liability, rather than ensuring a saving.