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Using discretionary trusts for estate planning

In our last article we looked in depth at absolute trusts and where they could be used. This time we are looking at discretionary trusts.

 

One of the attractions of a discretionary trust is its flexibility. When you are setting up a discretionary trust you don’t need to decide who will benefit, what they will receive or when they will get it. The settlor (the person creating the trust) just needs to list all the potential beneficiaries – basically anyone they think they may wish to benefit from the trust. These don’t need to be named individuals as you can use a class of beneficiary – such as “all my children, all my grandchildren and remoter issue”. This allows the trust to cover different generations, and could even include people that aren’t yet born as long as they fall into one of the stated “classes”.

 

Discretionary trusts can run for up to 125 years, so there is plenty of scope to skip one or more generations if appropriate. For example, if the settlor’s children were already wealthy and had their own inheritance tax (IHT) liability, the trustees may decide to skip the children and aim to help the grandchildren or even great grandchildren in the future. The main thing when using a “class” of beneficiary is that it needs to be identifiable – so something like ‘children’, ‘grandchildren’, ‘nieces and nephews’ can be identified, but you couldn’t use something like ‘all my friends’ because how would the trustees know who you think of as friends?

As with absolute trusts, it is possible to use a draft trust deed from the provider of the investment. This usually comes free of charge and with a recommendation that you seek your own legal advice. However if you wanted a bespoke discretionary trust to exactly match your wishes you could get a solicitor to draw one up for you as long as you were willing to pay for that service.

 

Let’s consider an example:

 

Lisa

Lisa has been speaking to her professional adviser and has been informed that if she were to die now (in the 2017/18 tax year) she has an IHT liability of £150,000. Her total estate is valued at £800,000 and she would have her standard nil rate band (£325,000) plus a residence nil rate band (£100,000) to offset against this, leaving a taxable estate of £375,000 at 40% = £150,000. Although Lisa hasn’t made any large gifts to date, she regularly makes gifts each year for birthdays and Christmas and this uses up her annual exemption of £3,000. (Every individual gets an exemption of £3,000 each year which means they can gift this amount without there being any seven year clock attached to it – it drops out of their estate immediately.)

 

Like many people, Lisa would prefer her estate to pass to her chosen beneficiaries, rather than the taxman being her largest beneficiary, so she discusses her options with her adviser and decides to make a gift into a discretionary trust. Lisa doesn’t want to use an absolute trust as she hasn’t decided exactly who she wants to benefit and how much she wants any particular person to get, plus some of her close family members are already adults and she doesn’t want them to benefit immediately, she would prefer them to get something after she has died.

 

Lisa decides to gift £325,000 (the current nil rate band) into a discretionary trust and she uses the following classes of beneficiary: Nieces, nephews, brothers and sisters.

 

Lisa only has one son, and she won’t be having any more children, so instead of including the class of “all my children” she names her son – Jack Whitefield. Even though Jack is named – he is still just a potential beneficiary. He doesn’t have any right to claim any of the trust assets. Lisa has two sisters, one brother, two nieces and three nephews.

 

The first thing to note is that Lisa doesn’t need to tell them they are potential beneficiaries and, because it is a discretionary trust, one or more of them may never receive any benefit from the trust. The trustees have full discretion to decide who gets a benefit, what they get and when they get it. This leads us onto a very important point. Lisa needs to choose trustees to look after and manage the trust and trust assets – and she needs to choose them very carefully as she is expecting the trustees to carry out her wishes after she has died. What she doesn’t want to happen is for the trustees to favour one or more of the potential beneficiaries over the others. The trustees must be impartial when deciding to make a payment out of the trust.

 

For example if she appointed both her sisters as trustees then, after Lisa dies, the trustees (her sisters) may decide to pass the trust assets to their children and not pass anything to their brother’s children or to Lisa’s own son. Where this is a concern, Lisa may decide to use an independent trustee (perhaps her solicitor or accountant or perhaps a professional firm of trustees. Note that professional trustees usually charge for their services).


After consideration, Lisa appoints herself and her two sisters as trustees. She explains to her sisters what her intentions are with the trust. She would like to help her son and her nieces and nephews with university costs, if appropriate, and she would also like to help any of the potential beneficiaries if a particular need arose where they could use some financial help.

 

Once the trust is up and running the seven year clock will start ticking on the original gift of £325,000. This means that if Lisa survives for seven years the value of the original gift will drop out of her estate for IHT purposes. If we assume her other assets remain the same, then in seven years’ time her IHT liability will be as follows:


£800,000 - £325,000 (gift made seven years ago) = £475,000


£475,000 - £325,000 (standard nil rate band remains frozen at this level until at least 2020/21 and for the purposes of this example we will keep it at £325,000) - £175,000 (residence nil rate band rate from 2020/21 and for the purposes of this example we will keep it at £175,000) = no taxable estate


Eight years after creating the trust Lisa’s son has secured a place at university and the trustees agree to give Jack £4,000 towards his university fees. The following year, one of her nieces, Lucy, gets into college and the trustees agree to give Lucy £4,000 towards her fees.

 

The trustees can continue to decide who gets what and when they get it. Most trusts require a minimum of two trustees, unless a professional trustee firm is appointed. As Lisa appointed her two sisters along with herself as trustees, this means when Lisa dies there will still be two trustees able to act so there will be no delay in having to appoint a second trustee at that time. Bear in mind as people get older there may come a time when one or more of the trustees would like to step down and resign from their role as trustee and this can be done. Most providers will be able to offer a “Deed of appointment and retirement of trustees”. This allows them to appoint a new trustee in replacement of the individual wishing to resign and ensures there is always a minimum of two trustees on the trust at any given time.


There are some points to note in relation to discretionary trusts:

 

  • A transfer of assets to a discretionary trust is a “chargeable lifetime transfer” (CLT) and there would be an immediate lifetime tax charge if the original investment, plus any other CLTs made in the previous seven years, exceeds the standard nil rate band (currently £325,000). The lifetime tax charge is 20% on the excess above the available standard nil rate band.

 

  • There is the potential for a periodic tax charge on every 10th anniversary – the maximum charge would be 6% on the excess above the available standard nil rate band at that time.

 

  • There is the potential for an exit charge when property leaves the trust. This will only arise in the first 10 years if there was an immediate lifetime tax charge at outset, or during any subsequent 10 years if there was a periodic tax charge at the preceding 10-yearly anniversary.

 

  • This type of discretionary trust does not allow the settlor access to any of the trust funds – so Lisa would not be able to benefit in any way. If Lisa was included as a beneficiary then the value of the trust would be included in her estate.
  • If Lisa died in the first seven years then this trust would claim £325,000 of her standard nil rate band.
    Lisa’s discretionary trust is a straightforward gift trust – because she was prepared to gift this money and not retain access for herself in any shape or form, but there are other types of discretionary trust where the settlor can retain a right to something for themselves.

 

A discretionary loan trust allows the settlor to lend money to the trustees whilst retaining the right to have their loan repaid at any time. What they are achieving, from an IHT point of view, is they are giving away the growth on the loan (this is outside their estate from day one) and that growth accumulates inside the trust for the beneficiaries.

 

A discretionary discounted gift trust allows the settlor to retain a right to a fixed level of income (usually up to 5% of the original investment) each year and this continues for life, or until the trust fund runs out if they live long enough.

 

A flexible reversionary trust is a discretionary trust with an annual reversion for the settlor (with the trustees’ approval) – so the settlor can decide each year, before the plan anniversary, whether or not they need something back from the trust for their own use.

 

With so many options available please speak to your professional adviser who will be able to explain which option best meets your own requirements.

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