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What is a discretionary trust?

Discretionary trusts are typically used where the settlor wishes the trustees to have maximum control over who will benefit and when. They can be created during lifetime or upon death. The beneficiaries won't have an automatic entitlement to the trust income or capital. The trustees can decide:

• how much income or capital is paid out
• which beneficiaries to make payments to
• when and how often the payments are made

The trustees can accumulate income within the trust if they choose not to distribute it. The accumulation period for income on older trusts may be limited.

A discretionary trust may have named beneficiaries but will frequently contain classes of potential beneficiaries such as children, grandchildren and/or other family members. The settlor will normally be a trustee to ensure that the trustees’ discretionary powers are exercised in line with their wishes.

To help guide the trustees in how to exercise their discretionary powers the settlor may provide them with an expression of wish sometimes known as a letter of wishes. This would not be a legally binding document but can provide clear guidance to the trustees.

The price for this level of control and flexibility is a more onerous tax regime than some other types of trust. Discretionary trusts are subject to the IHT relevant property regime. Gifts into them are chargeable transfers and the trust may be subject to periodic and exit charges. Trust income and gains are subject to the trust rates of tax.

Discretionary will trusts were commonly used in IHT planning to ensure that married couples both took advantage of their nil rate bands. On first death, an amount up to the nil rate band was put in trust for which the survivor was also a beneficiary, with the balance of the estate passing IHT free to the survivor. There has been less need for this type of arrangement since October 2007 when it became possible for the nil rate band of a deceased spouse/civil partner to be claimed by the survivor. They may, however, still be used for IHT mitigation where the settlor expects the investments in the trust to grow at a quicker rate than the IHT nil rate band.

Discretionary will trusts are still popular for non-tax reasons such as control, flexibility and asset protection.

Rights to the trust fund

No beneficiary has an automatic entitlement to trust income or capital. The trustees have discretion over whether to pay out income or add it to the trust capital. They can also decide when to make capital payments to beneficiaries.

Inheritance tax

IHT on creation of trust

Lifetime gifts into discretionary trusts are chargeable lifetime transfers (CLTs).  IHT will be charged at the lifetime rate of  20% on the amount above the settlor’s nil rate band. There is no 20% lifetime tax on discretionary will trusts as the estate pays the IHT at  the death rate of 40% on amounts in excess of the available nil rate band.

 If the settlor also pays the tax, this is regarded as a further gift, and the tax must be grossed-up to value the ‘loss’ to their estate. This gives an effective rate of 25%. The nil rate band available to the settlor is reduced by the value of any other chargeable transfers made by the settlor in the preceding seven years. Potentially exempt transfers can be ignored.

The settlor's annual exemption can cover up to £3,000 per settlor and can be set against a larger gift. So a couple who have not used the exemption in the current or previous tax year could have up to £12,000 of their transfer to a discretionary trust treated as exempt.

The normal expenditure from income exemption may also be used in conjunction with gifts to discretionary trusts. This can be used for regular gifts if the settlor has sufficient excess income to cover the gifts without dipping into their capital. Usually, this exemption is claimed on death by the settlor's executors. However, during life the transfers should be treated as if the exemption did not apply, Usefully when the settlor reaches the IHT100 reporting limits for gifts into a discretionary trust, they must notify HMRC. HMRC will then decide if the exemption will be given. This reporting limit is usually met when they have made cumulative gifts of 100% of the nil rate band.

Business and agricultural relief may also reduce the value of eligible assets transferred to the trust.

Additional IHT may be payable if the settlor dies within seven years of creating the trust. The gift will become chargeable at the death rate of 40%, and potentially exempt transfers that become chargeable because they were made within seven years of the settlor’s death must be taken into account. There's a reduction in the amount of tax payable if death occurs after three but before seven years. This is known as ‘taper’ relief. Credit is given for any lifetime tax already paid, but no reclaim is possible if this exceeds the liability on death.

Business and agricultural relief given when assets were transferred into trust may be removed if

• the trustees no longer hold the asset
• the asset is no longer eligible for relief

If the trustees have sold the qualifying assets, or if the assets no longer qualify for business property relief because for example they were AIM shares that have publicly listed on the Stock Exchange, there may be additional IHT due on the settlor's death within seven years.

10 year periodic charge

Discretionary trusts are ‘relevant property’ trusts. Because the trust assets are not included in the taxable estate of any of the beneficiaries, the trust itself will be assessed to IHT every 10 years. This is known as the ‘periodic’, or ‘principal’ charge.

Broadly, on each 10 year anniversary the trust is taxed on the value of the trust less the nil rate band available to the trust. The rate they pay on this excess is 6% (calculated as 30% of the lifetime rate, currently 20%). If the value of the trust is less than the nil rate band, there will be no charge.

Calculating the periodic charge and reporting to HMRC can be complex and will often be done by an accountant or solicitor, but the steps in the calculation are as follows:

* After deducting any business property relief (BPR) and agricultural property relief (APR)

** Related settlements include trusts set up on the same day as the trust being taxed

*** Includes transfers that were PETs when made and have become chargeable on death.

Additions to trust

If property is added to a trust between 10 year anniversaries, these will already be included in the value on the periodic charge date. But because these assets have not been relevant property for the full 10 year period, the ‘actual rate’ applying to those assets will need to be adjusted. The adjustment made is to multiply the actual rate by (40 - X) /40) where X is the number of complete three month periods between the creation (or last 10 year anniversary) and the date of the addition. It's therefore important for trustees to keep good records of when additions are made and how they're invested.   

Where regular payments have been made using the normal expenditure out of income exemption, these additonal rules will apply to the assets in trust. While the expenditure out of income exemption can reduce IHT for the settlor, it is irrelevant for the calculation of 10 year IHT charges which should be based on the value of the assets to the trustees. 

IHT on payments of capital out of trust (exit charge)

An IHT ‘exit charge' is calculated when capital (not income) is distributed to a beneficiary. The rate of tax applied to the capital leaving the trust is based upon.

• Exits after the first periodic charge date. The rate of tax applied at the last 10 year anniversary recalculated using the nil rate band at the time of the exit .
• Exits in the first 10 years. The rate is calculated on a notional chargeable transfer of the trust assets immediately after they entered the trust. The effective rate is calculated based on notional tax charge of 30% of lifetime rate of 20% even if the trust was created on death

In both cases the rate is then apportioned based on the number of three month periods (quarters) which have elapsed since the last 10 year anniversary/inception of the trust.

As a rule of thumb, if no tax was due on creation of the trust there's normally no IHT due on any distributions made in the first 10 years. However, this may not be the case where

• the settlor dies within seven years of an earlier PET
• an exemption has been used to reduce the settlor's IHT as exit charges are based on the value to trustees
• an asset that benefited from business or agricultural relief no longer qualifies or has been disposed of
• the trust is a will trust where the transferable nil rate band is  available - periodic and exit charges are only ever calculated using the standard nil rate band.

A special rule also applies in the case of a discretionary will trust so that there will be no IHT exit charge on distributions within two years of the settlor's death. Instead it's treated for IHT as having been made by the deceased at the time of their death.

Calculating an exit charge and reporting to HMRC can be complex and will often be done by an accountant or solicitor.

Calculation of an exit charge during first 10 years

* This is the value in the trust immediately after it has been created. It may not be the same value as the chargeable transfer made by the settlor e.g. where settlor paid the tax on a CLT. Unlike the periodic charge, business and agricultural property relief should be ignored when calculating the initial value (but may be available to reduce the value of the exit if assets qualify).

** Related settlements include trusts set up on the same day as the trust being taxed

*** Includes transfers that were PETs when made and have become chargeable on death.

**** The actual rate is reduced by the number of complete three month periods that have elapsed from date of creation to the distribution date.

If the trustees pay the tax on exit, as opposed to the beneficiaries, then the actual rate of tax must be grossed-up as the loss to the trust is not just the distributed capital, but the tax paid by the trust as well.

Exit charge after 10 years

After the first 10 year period, IHT is charged at the effective rate that applied at the last periodic charge but recalculated using the nil rate band at the date of the exit. As with exits in the first 10 years, the charge is based on the number of quarters that have elapsed but from the last 10 year anniversary rather than commencement.

The rate of tax must be grossed up if paid by the trustees. However, grossing up is not necessary if all of the trust property is to be appointed out of the trust.

There will be no exit charge if the distribution occurs within three months of a tenth anniversary date.

Examples of how IHT is applied to discretionary trusts can be found in our practical guide Trust IHT charges.

Joint settlors

Where the trust is created by joint settlors, each settlor's portion of the fund is treated as a separate trust, or ‘settlement’ for IHT with its own nil rate band. The rate of IHT payable on periodic charge dates or exits is calculated independently. As long as the two settlors have paid the same amount to the trust and have made no chargeable transfers in the seven years prior to its creation, the charges will be the same in respect of each settlement. However, if there are differences in the amounts gifted, investments made, or the seven year history of chargeable transfers, the IHT charges may differ for each settlement.

Income tax

From 6 April 2024 the £1,000 standard rate band has been abolished.

Trusts with total income of less than £500 will pay no income tax. If total income exceeds this amount, the whole of the income (not just the amount over £500) is taxed at the ‘trust’ rate. The trust rate is equivalent to the additional rate for individuals, i.e. 45% or 39.35% for dividends.

Income distributed to a beneficiary will be paid net with a certificate (R185) showing the tax accounted for by the trustees at 45% (the tax credit). The beneficiary will be liable to tax at their own marginal rate on the gross distribution, but if this is more than the tax credit, some or all of the tax credit can be reclaimed.

Taxation of trust

Different rates are paid on dividends than all other income:

Trust low income exemption

From 6 April 2024 the £1,000 standard rate band has been abolished and replaced with an exemption for trusts with income below £500. Trusts with income of less than £500 will have no tax to pay.

If the settlor has created more than one settlement, the £500 will be split equally between each, subject to a minimum of £100  per trust.

If the trust income is over £500, the whole amount of the trust's income is taxed at the trust rates. The dividend and personal savings allowances are not available to trustees.

The tax pool

Trustees will keep a record of income tax paid in what is known as the ‘tax pool’.  The tax pool could consist of tax paid at 39.35% and 45%. But, each time they make an income distribution to beneficiaries, they must have enough in the tax pool to cover the 45% credit they give to the beneficiary with the payment. Or the trustees must make up the difference.

Taxation of beneficiary

A beneficiary will receive income from a discretionary trust as trust income (classed as non-savings income) with a 45% tax credit (shown on the form R185). They can reclaim all or part of this depending on their own tax position. In the example above, the beneficiary receives gross trust income of £1,000 and a tax credit for £450. An additional rate taxpayer will not be able to reclaim any of this tax. On the other hand, a non-taxpayer could reclaim all of the £450 tax credit. Basic rate and higher rate taxpayers can reclaim £250 and £50 respectively.

Settlor interested trusts and parental settlements

Trust income is treated as the settlor’s if they and/or their spouse/civil partner can benefit from the trust. This does not include the former spouse/civil partner and so trusts set up for a widow(er) won't be affected.

The trustees still have to deduct tax at the trust rate. The tax payable by the trustees does not form part of the tax pool.

The settlor is assessable on the income regardless of whether they actually benefit and the income retains its source nature, e.g. dividend, savings income or rent. Credit is given to the settlor for the tax deducted by the trustees. A settlor who is not an additional rate taxpayer may reclaim the difference between the trust rate and their own marginal rate from HMRC.

Any tax reclaimed by the settlor must be repaid to the trustees. As this is not a discretionary payment to the trust, it won't be considered a transfer of value for IHT.

A beneficiary receiving income from the trustees does not have any further income tax liability, but neither will they be able to reclaim any of the tax paid.

Parental settlements

Special rules also exist where a parent sets up a trust for their minor (under 18) unmarried child. If income paid to or for the benefit of the child exceeds £100 per annum, all trust income will be assessed on the settlor. The £100 annual limit is per parent and per child.

Investment bonds

Investment bonds don't produce an income and there's no income tax charge unless money is withdrawn from the policy and a chargeable event occurs. This may help to minimise tax reporting requirements for the trustees if a chargeable event can be avoided, even though the underlying investments may actually produce income.

When a chargeable event occurs on a bond owned by trustees, any gain will be assessed to income tax on:

• the settlor if alive* and UK resident
• otherwise, the trustees if the trust is UK resident.

* The liability remains with the settlor throughout the tax year of their death.

The settlor will be taxed in the same way as an individual owning an investment bond. Top-slicing relief is available. Where there's more than one settlor, each will be assessed proportionately on the gain, based on how much they gifted to the trust.

The settlor can reclaim any tax payable from the trustees. If tax is not reclaimed, it will form part of the settlor’s estate for IHT unless they notify the trustees that no reclaim will be made. In this case, as a further gift has effectively been made, it could be regarded as a chargeable lifetime transfer for IHT.

Where the liability falls on the trustees, the trust rate applies. Top-slicing relief is not available for trustees.

Alternatively, the income tax liability could be transferred to the beneficiaries if the trustees wish to make a capital distribution from the trust and satisfy this by the assignment of a bond (or bond segments) to a beneficiary. The gains on subsequent surrenders would then be assessed on that beneficiary with top slicing relief available.

Capital Gains Tax

Gifts into trust

Lifetime gifts of existing assets into trust, other than gifts of cash or the assignment of investment bonds, will be disposals for CGT.

Any gains will be assessed on the settlor unless they elect to ‘holdover’ the gain. This election effectively postpones the taxation of the gain until the trustees sell the assets or transfer them to a beneficiary. Holdover is available because the transfer to trust is also a chargeable transfer for IHT.

Holdover relief is not available where the settlor, their spouse/civil partner or their minor (under18) unmarried child can benefit from the trust (these are known as 'settlor interested' trusts).

Assets transferred to trust on the settlor’s death won't normally have been subject to CGT. The trustees will have acquired the assets at their market value at the date of death.

During the life of the trust

If the trustees dispose of trust assets (for example, if they sell a mutual fund or a property) the gains are calculated in the same way as for an individual and taxed at the trust rates of CGT. The trust rates are 20% or 24% for residential property (20% or 28% 2023/24). If the disposal is after 30 October 2024 the trust rate is 24% on all assets.The trustees are only entitled to half the individual annual CGT exempt amount. However, this exemption is shared equally between all trusts created by the same settlor, subject to a minimum of one fifth of the trust exemption.

Trustees can also claim principal private residence (PPR) relief on the disposal of residential property that has been occupied by a beneficiary of the trust as their only or main residence.

Transfers out of trust

There will be a CGT disposal if the trustees transfer chargeable assets to a beneficiary. This could happen if the trustees make a discretionary payment of capital to a beneficiary.

The trustees can jointly elect with the relevant beneficiary for the gain to be held over. This postpones the gain until the beneficiary ultimately disposes of the asset (except on their death). This is possible even if the trust is settlor interested. This can be advantageous as the beneficiary has the full annual exemption and may pay a lower rate of CGT. Tax on capital gains can therefore be deferred both going into, unless settlor interested, and coming out of discretionary trusts.

Where trustees want to utilise holdover relief, they must take care not to pass assets to a beneficiary within the first three months of the trust being created, or within the first three months following a 10 yearly IHT charge. In such circumstances, holdover relief won't apply unless the transfer is of business assets.