Lifetime Discretionary Trusts

Wills, Trusts & Probate insights

Please note that these notes are in no way intended to be exhaustive. Their purpose is to give clients some insight into the nature of a discretionary trust and the work involved in the creation of a discretionary trust.

 

Why a lifetime discretionary trust?

Individual clients (“the Settlor”) can settle their Nil Rate Band on a lifetime discretionary trust with no immediate Inheritance Tax implications. The Nil Rate Band amounts to £325,000. Any monies settled into the Trust in excess of an individual’s Nil Rate Band will give rise to an immediate charge to Inheritance Tax at the 20% lifetime rate.

If the Settlor settles all of their Nil Rate Band on a discretionary trust then once seven years has elapsed from the date that the monies were settled the Settlor will enjoy a fresh Nil Rate Band. Therefore, the Settlor could create another discretionary trust at that point if he or she wishes.
If the Settlor dies within seven years of the creation of the trust then the amount settled will reduce the Nil Rate Band available on their death to set against their estate for Inheritance Tax purposes.

N.B. The Settlor’s available Nil Rate Band for settling on the discretionary trust will be reduced by any chargeable lifetime gifts made in the preceding seven years in excess of any allowable exemptions. It is therefore vital that the Settlor has a complete and clear record of any significant gifts made in the seven years prior to the proposed Settlement.

 

What is a discretionary trust?

As its name suggests a discretionary trust gives a wide discretion to the trustees of the trust as to how to deal with its assets for the benefit of the trust beneficiaries.

Generally, a discretionary trust is set up with a broad class of beneficiaries to give the trustees as much flexibility as possible. The Settlor and the Settlor’s spouse cannot be beneficiaries of the trust.

By law a trust cannot last for more than 125 years from the date of its creation. The trust can be brought to an end at any time by the trustees exercising their discretion and appointing all of the capital monies within the trust out to one or more of the members of the class of beneficiaries.

 

Who can be a trustee?

The Settlor can be a trustee but can never be the sole trustee. Generally, there are at least two trustees and there cannot be more than four trustees.

 

What guidance should there be?

It is essential for the Settlor to complete at the time that the trust is created a detailed letter giving guidance to the trustees as to how the monies held within the trust are to be utilised for the benefit of the different members of the class of beneficiaries.

The Settlor can during his or her lifetime update that letter to reflect the changes in the circumstances of the beneficiaries.

Please note that the letter of wishes, as its name suggests, is a non-binding document. The preface to the letter will make it clear that it is purely there to give the trustees guidance and that they will need to consider whether or not the requests contained in the letter are appropriate having regard to the potential beneficiary’s circumstances at the relevant time.

 

What are the tax implications?

As advised above, provided the trust is created with a sum equal to or less than the Settlor’s available Nil Rate Band there will be no immediate

 

Inheritance Tax implications.

The tax implications of running the trust are as follows:-

Inheritance Tax

There is a potential charge to Inheritance Tax every ten years and when assets exit the trust.

Prior to the tenth anniversary of the creation of the trust it will be advisable for the trustees to consider whether they wish the trust to continue beyond the 10 year anniversary and the tax implications of this.

If there is an Inheritance Tax liability there is a complex formula for calculating the rate of tax. Currently the rate of tax cannot exceed 6%.

 

Capital Gains Tax

If assets are held on the terms of a discretionary trust then when assets are appointed out of the trust absolutely to a beneficiary the trustees can make an election for holdover relief. This has the benefit of postponing a potential Capital Gains Tax liability. If the trustees make disposals during the operation of the trust they will be taxed on gains on residential property at the rate of 28% and gains on other chargeable assets at the rate of 20%.

 

Income Tax

Trustees will pay Income Tax on trust income up to a limit of £1,000 at the lower rate of 20%. Income received in excess of £1,000 will be taxed at the trust rate. This is currently 45% on rents or interest and 37.5% for dividends. If income is paid out to a beneficiary who is not a tax payer or a basic rate tax payer then there is the opportunity to recover some or all of the Income Tax paid.

 

Administration of the Trust

If monies are invested in income generating investments then the trustees will need to file an annual Trust Tax Return with the Revenue.

If the trustees dispose of assets giving rise to a gain for Capital Gains Tax purposes then once again the trustees will need to return this gain to the Revenue.

The trustees will also need to maintain trust accounts to track the changes in the trust assets over the years.

 

ADVANTAGES AND DISADVANTAGES OF DISCRETIONARY TRUSTS

The advantage of a discretionary trust is its flexibility and the fact that it enables the Settlor to take funds out of their estate for Inheritance Tax purposes while continuing to have a say in how the monies may be utilised for the benefit of, in most cases, family members.

Where the beneficiaries are the Settlors’ children then the attraction for clients is that funds can be withheld if there are concerns about a child’s ability to manage funds or the stability of their marriage.

The main disadvantage is the trouble and expense of administering a continuing trust.

 

These notes are not exhaustive and are meant as a basis for discussion with your legal adviser. If clients wish to discuss any of the above, please contact our Private Client Team 020 8940 4051 who will be pleased to help you

IMPORTANT: this information is intended to be a general statement of the law. No action should be taken in reliance on it without seeking specific legal advice.

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