Laura Stafford
Solicitor & Head of Private Client
Phone: 0113 200 7480
Email: ls@averywalters.com
Our Private Client specialist’s guide to Lifetime Discretionary Trusts
Dealing with your estate and planning for the future and for tax mitigation can be stressful and confusing especially as there are a wide range of options which are available to you to arrange your estate.
Trusts are just one option, and discretionary trusts are one of many types of trust that you can make.
This guide will help you to understand lifetime discretionary trusts.
What is a discretionary trust?
For a trust to be discretionary, it must give no beneficiary an automatic entitlement to assets or income. Instead, a discretionary trust gives the trustees the responsibility of deciding who is to become a beneficiary and when and how they should receive any benefit.
This means that the trustees are responsible for determining how much a beneficiary should receive and may even decide not to give some beneficiaries anything at all dependent on their circumstances.
An example may be where a beneficiary is going through a divorce or having gambling issues. The trustees may decide not to provide any funds to this beneficiary as they will be lost or wasted.
What are the benefits of this type of trust?
A Discretionary Trust Will may be worth considering if you can relate to any of these circumstances: -
• You have a high value estate which you wish to preserve for future generations. This may include business interests or a property portfolio.
• You have a ‘blended family’ i.e., second/third marriage with children and stepchildren and want to adequately provide for all parties without conflict between them.
• You do not like or trust your proposed beneficiary’s partner and worry they would be able to access the funds.
• Your proposed beneficiaries are disabled, vulnerable or suffer from learning difficulties (whether from birth or otherwise) and unable to manage funds for themselves or are at risk of being exploited.
• Your proposed beneficiaries are in care, and you wish to preserve your funds/ being used to pay ongoing care fees.
• Your proposed beneficiaries are in receipt of means-tested benefits.
• Your proposed beneficiaries are suffering from mental health issues which means that they are unable to manage funds for themselves or are at risk of being exploited.
• Your proposed beneficiaries are suffering from gambling, drug or alcohol addictions.
• Your proposed beneficiaries are potentially going to divorce/dissolve their marriage/civil partnership and you wish to protect assets you would otherwise gift them from being used up in settlements.
• Your proposed beneficiaries are having financial difficulties and you wish to protect funds from being used up in bankruptcy/insolvency petitions.
• You want to gift assets into the trust to mitigate your own estate for inheritance tax purposes.
How is a discretionary trust set up?
A lifetime discretionary trust instrument can be set up in your lifetime in writing. This is signed by you as the ‘settlor’ i.e. the person ‘setting up’ the trust.
This trust instrument will contain all of the terms of the trust i.e. the potential beneficiaries, default provisions and what the trustees can and cannot do. It will also stipulate who the trustees are and set out how other trustees can be appointed.
Legal documentation will then be drawn up to transfer your chosen assets into the trust i.e. a stock transfer form for share, land registry paperwork for any property etc.
A letter of wishes should also be prepared.
What is the significance of a Letter of Wishes?
It is advisable to prepare a Letter of Wishes for your trustees when setting up a Discretionary Trust Will.
This Letter of Wishes is not legally binding, and the trustees are not required to follow this. However, it provides some guidance and an explanation of your intentions for the use of the trust funds.
Letters of Wishes are usually private and confidential between you and your trustees but in some cases are disclosed to beneficiaries.
What are the tax implications?
Discretionary trusts generally fall into the ‘relevant property regime’ which applies special rates of tax.
Relevant property includes assets such as property, money, and shares.
Entry charges
If you make a gift into a discretionary trust during your lifetime and the open market value of the gift exceeds the ‘nil rate band’, which is currently £325,000, then you will have to pay Inheritance Tax at 20% on anything above the nil rate band. You must be aware that any gifts or transfers made in the previous 7 years will reduce the available nil rate band. If the tax is to be paid by you, and not deducted from the assets being transferred into the trust, grossing up applies and the rate of tax will be 25%.
If you die within 7 years of making a transfer into a discretionary trust, any Inheritance Tax charges will be recalculated at the death rate. The tax will also be subject to a relief, known as ‘taper relief’ which begins 3 years after the transfer and reduces the amount of tax to pay every year that passes.
A periodic charge
Every 10 years, the value of the trust fund is taxed at a maximum rate of 6%. This is payable by the trustees out of the trust fund.
When the trust is created the 10-year periods are automatically counted. If the assets are not relevant property for the full period, then this charge is reduced.
Exit Charges
An exit charge is applied over any reduction in the value of the trust fund, for example when assets are distributed to the beneficiaries. The exit charge is proportional to the number of quarter years that have passed in the current 10-year period.
An exit charge may also apply in situations where the assets no longer fall under the relevant property regime.
The exit charge rate is taxed at a maximum rate of 6%.
In additional to this, any income which is generated by the trust is taxed at the trustee rate (higher rate) and any gains are also taxed at the higher trustee rate.
IHT mitigation
When assets are gifted into a trust, these assets can be disregarded from your estate for inheritance tax calculations if you survive 7 years.
However, you cannot benefit from the assets in trust, or as a beneficiary of the trust for this to take place.
If you retain a benefit, then the HMRC will consider that you still own these assets, and they therefore form part of your estate for inheritance tax purposes and calculations. This is called a ‘gift with reservation of benefit.’
Are there any downsides to doing this?
The downside to this arrangement is that it is restrictive for the beneficiaries who need to request funds from the trustees each time they are required.
There is also a substantial burden placed on the trustees to administer and manage the trust, especially if they are lay trustees i.e., friends or family members as opposed to professionals.
The management and running of a trust can also be costly and complex and it is common that professional assistance is required from a solicitor or accountant.
What responsibilities do my trustees have?
Trustees should meet at least annually to consider making distributions from the estate.
They should also do the following: -
• Prepare and keep accounts.
• Annual tax returns
• Take financial and legal advice
• Ensuring the trust is registered with HMRC
Can the trust be brought to an end?
There are usually flexible powers contained in discretionary trusts to allow the trustees to bring the trust to an end by giving all the assets to the potential beneficiaries.
If the funds run out, then the trust would also come to an end.
There may also be powers within the trust to allow the trustees to transfer the funds into a different trust on different terms.
The maximum length of time that the trust can run is 125 years. At this point, any funds remaining would be distributed to default beneficiaries set out in the trust instrument.
At Avery Walters our team of specialists can provide pragmatic and cost-effective advice about Trusts, Wills and Probate.
Contact us on 0113 2007480 or email us on info@averywalters.com to arrange your free initial, no obligation consultation with a specialist.
* Laura Stafford is the SFE accredited memberand a full member of STEP