Anaya Nolan
Discretionary trusts are a type of trust law in England, Australia, Canada, and other common-law jurisdictions. They are a legal arrangement where assets are managed by trustees for the benefit of beneficiaries. Discretionary trusts offer flexibility and control to the settlor in managing their estate and ensuring their specific wishes and changing circumstances are fulfilled. The trustees have complete discretion over how and when to distribute the trust's assets, including the power to determine which beneficiaries will receive payments and how much. This added flexibility, however, comes with higher costs and tax implications, such as the relevant property regime for inheritance tax. Discretionary trusts can be complex, requiring trustees to understand trust and tax laws, and they may need to seek independent legal advice.
| Characteristics | Values |
|---|---|
| Definition | A legal arrangement where assets are managed by trustees for the benefit of a group of beneficiaries. |
| Trustee's role | Trustees have complete discretion over how and when to distribute the trust's assets. |
| Beneficiaries | Beneficiaries are classified only as potential beneficiaries. They do not become actual beneficiaries until the trustees decide to pass funds to them. |
| Settlor's role | The settlor is the person who puts their assets or money into the trust. They may appoint themselves as a trustee. |
| Types | Discretionary trusts can be testamentary trusts or be set up during the settlor's lifetime. |
| Tax implications | Discretionary trusts are subject to the relevant property regime for inheritance tax purposes, which can be costly. They are also subject to trust rates of tax. |
| Privacy | Unlike wills, trust arrangements are not public documents, providing confidentiality. |
| Flexibility | Discretionary trusts are highly flexible, allowing trustees to respond to changes in circumstances. |
| Control | Trustees have significant control over trust assets, which can be a downside as their decisions may not align with the settlor's intentions. |
| Complexity | Discretionary trusts can be complex, requiring trustees to understand trust and tax laws. |
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Trustees' duties and rights
A discretionary trust is a type of trust commonly used in UK law, where the trustees have the discretion to decide how to distribute the trust's income and capital among the beneficiaries. The trustees' duties and rights are an important aspect of discretionary trusts, as they play a crucial role in managing and administering the trust. Here is an overview of the key duties and rights of trustees under UK law:
Duties of Trustees:
- Act in the Best Interests of Beneficiaries: Trustees have a fiduciary duty to act in the best interests of the beneficiaries as a whole. They must exercise their discretion reasonably and in good faith when making decisions about distributing trust income or capital. Trustees should also consider the current and future needs of the beneficiaries and treat them impartially, unless the trust deed provides otherwise.
- Invest Trust Funds Prudently: Trustees are responsible for investing the trust's funds prudently and managing the trust property wisely. They must follow the "prudent person" rule, which means investing in a way that a prudent person would in managing their own affairs. Trustees should also consider the trust's investment objectives, the needs of the beneficiaries, and the level of risk appropriate for the trust.
- Keep Accounts and Records: Trustees are required to keep accurate and up-to-date accounts and records of the trust's financial activities. This includes maintaining proper books of account, recording all receipts and payments, and preparing annual financial statements. Trustees should also be prepared to provide beneficiaries with reasonable information and reports about the trust's administration.
- Exercise Skill and Care: Trustees must carry out their duties with reasonable skill and care. They are expected to use their personal skills and knowledge and seek professional advice when necessary. Trustees can be held personally liable for any losses or damages caused by their negligence or breach of trust.
Rights of Trustees:
- Power to Invest: Trustees have the right to invest the trust's funds within the parameters set out by the trust deed and applicable laws. They can make decisions about the types of investments, buy and sell assets, and manage the trust's investment portfolio to generate income or capital growth.
- Power to Distribute Income and Capital: Trustees have the discretion to decide how much income or capital to distribute to the beneficiaries and when to make those distributions. They can also decide to accumulate income for future distribution or reinvest it for the benefit of the beneficiaries.
- Right to be Indemnified: Trustees are typically entitled to be indemnified out of the trust property for any personal liability they may incur while acting in their fiduciary capacity. This means that trustees can be reimbursed for any expenses or losses they may suffer as a result of carrying out their duties, provided they have acted honestly and reasonably.
Trustees should always act in accordance with the terms of the trust deed and any relevant laws, such as the Trustee Act 2000 and the Trusts (Capital and Income) Act 2013. They may also seek professional advice to ensure they are fulfilling their duties and protecting the interests of the beneficiaries effectively.
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Beneficiaries' rights
A discretionary trust is a type of trust where the beneficiaries and their entitlements are not fixed. Instead, the trustees are given discretionary powers to decide which beneficiaries will receive payments and how much they will receive. Trustees have a duty to exercise their discretion lawfully under the terms of the trust and in the best interests of the beneficiaries.
While the beneficiaries of a discretionary trust do not have an automatic right to receive funds, they do have certain rights and protections. Firstly, beneficiaries have the right to request specific documents from the trustees, such as contact details, trust accounts, trust assets, and liabilities. This right to information helps beneficiaries understand the trust's management and ensure that their interests are being considered.
Additionally, beneficiaries have the right to be treated fairly and have their best interests considered in all decisions made by the trustees. Trustees have a fiduciary duty to all potential beneficiaries, and beneficiaries can hold them accountable if they breach their duties. If a beneficiary is unhappy with a trustee's decision, they can request information and documentation to review the decision-making process.
In the case of a dispute, beneficiaries can apply to the court to have a trustee removed or replaced. However, it is important to note that beneficiaries cannot challenge a trustee's decision simply because they believe it to be unfair. The court will not compel a trustee to distribute funds in a particular manner, but it can order the replacement of trustees if necessary.
Furthermore, discretionary trusts can help protect the assets of irresponsible beneficiaries against creditors. Since the beneficiary has no claim to any specific part of the trust fund, none of the trust's assets can be attached by creditors. This provides a layer of protection for beneficiaries who may be vulnerable or financially naïve.
While discretionary trusts offer flexibility and certain tax advantages, it is crucial for beneficiaries and trustees to understand their respective rights and duties to avoid potential disputes.
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Inheritance tax planning
Discretionary trusts are a type of trust law in England and other common law jurisdictions where the beneficiaries and their entitlements to the trust fund are not fixed. Instead, they are determined by the criteria set out by the settlor in the trust instrument. This means that trustees are given broad powers to decide how and when the money is distributed, making them one of the most flexible forms of trust available.
Discretionary trusts are frequently used in inheritance tax planning due to their flexibility and the level of control they offer the settlor. They can be used to protect the assets of irresponsible beneficiaries against creditors, as the beneficiary has no claim to any specific part of the trust fund. This also means that none of the trust fund is vulnerable to attachment by the trustee in bankruptcy of any beneficiary.
However, it is important to note that discretionary trusts are subject to the relevant property regime for Inheritance Tax purposes, which can be more costly. This means that gifts into them are considered chargeable transfers, and the trust may be subject to periodic and exit charges. For example, when assets are given to the trust, they are taxed at 20%, and this rises to 40% if the settlor dies within seven years of the transfer. Additionally, the trust itself will be assessed for Inheritance Tax every ten years, known as the 'Periodic' or 'Principal' charge.
To ensure that their decisions align with the settlor's intentions, trustees can be given guidelines to follow. This can be done by leaving a letter of wishes along with the will, setting out the settlor's wishes regarding the circumstances in which beneficiaries should receive their assets.
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Tax burdens
Discretionary trusts are a separate legal entity, and the transfer of assets into the trust may come with a tax cost. For example, there may be an inheritance tax charge of 20% when assets are transferred into a discretionary trust. If the settlor has set up five or more accumulation or discretionary trusts, the tax-free limit for each trust is £100. Trustees are responsible for paying tax on income received by discretionary trusts. Discretionary trusts will always pay income tax at the highest rate of 45% (39.35% for dividends).
Discretionary trusts can be used to make gifts either during your lifetime or after your death. They are a popular method of estate planning because assets remain outside the beneficiaries' estates for inheritance tax purposes and are not included in any calculation for means-tested benefits. They can also be useful for income tax planning, particularly for grandparents or distant relatives who wish to provide income to minor children.
If a beneficiary is going through a divorce, a discretionary trust can ensure that assets from the estate won't pass to their former spouse. Similarly, if a beneficiary is bankrupt, a discretionary trust can protect the assets from being lost. A trust for a vulnerable person can benefit from favourable tax treatment.
Discretionary trusts may be subject to an IHT charge of up to 6% every 10 years, and when capital is paid out. The transfer of assets into and out of trust will be a disposal for CGT, but tax may be deferred using holdover relief.
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Letters of wishes
A letter of wishes is a non-legally binding document that is often used in conjunction with a discretionary trust in the UK. It is a way for the settlor (the person creating the trust) to provide guidance and instructions to the trustees without being legally binding. The letter of wishes is a private document and is not made public, which allows the settlor to include sensitive information and personal requests that they may not want to include in the formal trust deed.
The letter of wishes can cover a wide range of topics and instructions. For example, the settlor may want to provide guidance on how the trustees should exercise their discretion when distributing trust funds to beneficiaries. This could include factors to consider when making distributions, such as the needs and circumstances of each beneficiary, as well as any specific wishes the settlor has regarding the timing and amount of distributions.
Additionally, the letter of wishes can be used to appoint or recommend particular individuals for certain roles within the trust, such as guardians for minor beneficiaries or additional trustees. The settlor can also use this document to explain the reasons behind their choices, which can be especially useful in providing clarity and context for the trustees when carrying out their duties.
While the letter of wishes is not legally binding, it is still an important document that trustees should carefully consider. Trustees have a fiduciary duty to act in the best interests of the beneficiaries, and they are generally expected to respect the wishes of the settlor as long as they are lawful and do not conflict with the terms of the trust deed. However, it is important to note that trustees are not legally obligated to follow the instructions in the letter of wishes if they believe it is not in the best interests of the beneficiaries or if it would result in a breach of trust.
To ensure the effectiveness of a letter of wishes, it is important for the settlor to provide clear and concise instructions, as well as any relevant background information that could aid the trustees in understanding their wishes. It is also crucial for the settlor to regularly review and update the letter of wishes, especially if there are any changes in circumstances or relationships that could impact the trust or its beneficiaries.
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Frequently asked questions
A discretionary trust is a legal arrangement where assets are managed by trustees for the benefit of a group of beneficiaries.
Discretionary trusts are unique because the beneficiaries are classified only as potential beneficiaries. They do not become actual beneficiaries until the trustees decide to pass funds to them. Trustees have complete discretion over how and when to distribute the trust's assets.
Discretionary trusts are flexible and can be used for inheritance tax planning, allowing for gifts to be made to a range of people or charities. They can also be used to protect assets for future generations and to maintain flexibility in beneficiary distributions.
Discretionary trusts are subject to the costly relevant property regime for inheritance tax purposes. Gifts into them are chargeable transfers and the trust may be subject to periodic and exit charges.
A discretionary trust is set up through a legal 'trust deed' document which names the people involved and sets out the terms of the trust. Trusts may be established while the settlor is alive but can also be created through a will.
