Mercian Accountants recognizes the potential benefits of discretionary trusts for families looking to plan their asset protection and wealth distribution for future generations. This article aims to provide a comprehensive overview of discretionary trusts and how they can be used to save Inheritance Tax (IHT) on estates.

What are Discretionary Trusts?

A discretionary trust is a type of trust in which the settlor grants the trustees full control over who benefits from the trust and when. The settlor may set up the trust during their lifetime or upon their death. The beneficiaries do not have an automatic right to the trust’s income or capital, and the trustees are responsible for deciding how much income or capital is paid out, to whom, when, and how frequently payments are made.

Named Beneficiaries and Classes of Beneficiaries

Discretionary trusts can have both named beneficiaries and/or classes of beneficiaries, such as children, grandchildren, nieces, nephews, etc. If the settlor is not a trustee, they should provide a letter of wishes to guide the trustees on how they would like the trust to operate.

Saving on Inheritance Tax (IHT) and Capital Gains Tax (CGT)

Placing cash into a trust up to the value of the nil rate band (currently £325,000, subject to any previous gifts into trust in the last seven years) will result in no IHT or CGT on entry. Over the next ten years, as there was no entry charge, there will be no IHT to pay on any distribution. Note that there may be a CGT charge if other assets are added to the trust, but this can be held over, and our team can advise on this.

Once the settlor survives seven years, the assets settled will fall out of their estate for inheritance tax purposes, saving an IHT charge of £130,000 (on £325,000 assets settled).

Relevant Property Trusts and Inheritance Tax (IHT)

Discretionary trusts are classified as “relevant property” trusts, meaning that the assets held by the trust are not included in the taxable estate of any of its beneficiaries. The trust will be assessed for IHT every ten years, and the inheritance tax rate at this anniversary will not be more than 6% of the value of the assets.

Higher Rates of Income Tax

Discretionary trusts pay a higher rate of income tax, 39.35% for dividends and 45% for interest. However, this higher tax rate can work in the beneficiary’s favour, depending on the intended use of the funds.

Tax Pool and Tax Credit for Beneficiaries

The higher tax rates paid by a trust are placed into a “tax pool”, and when a distribution is made out of income directly to a beneficiary, they will receive a “statement of income from trusts” form R185. This grosses up the income distribution to the beneficiary, meaning they are given a 45% tax credit, which they can claim back, subject to their income. This tax repayment is for the beneficiary and does not return to the trust.

Example of Tax Credit Calculation

For example, if income distributions are made up to £28,700, this would carry a tax credit of £23,481.82. Therefore, the total the beneficiaries could receive would be £52,181.82, subject to their circumstances. The tax paid by the trustees could be claimed back by the beneficiary.

School Fees and Discretionary Trusts

A grandparent would be the ideal person to establish a discretionary trust to pay school fees. If the trust distributes income to the settlor’s child, it would be considered a settlor-interested trust, making the income taxable against the parent. This is not a desirable outcome, as not only would the settlor have to pay tax on that income, but the child would be unable to recoup the tax paid by the trust.

If the settlor is a parent, they can avoid paying school fees from income by instead distributing capital or treating the payment as a loan to the child.

What is a Discretionary Trust?

Definition:

A discretionary trust is where the settlor allows the trustees to determine who will benefit and when rather than having a set distribution plan. The beneficiaries do not have an automatic entitlement to the trust income or capital.

Beneficiary Classes:

A discretionary trust may have named beneficiaries and/or classes of potential beneficiaries, such as children or grandchildren.

Letter of Wishes:

The settlor may guide the trustees through a letter of wishes, which is not legally binding but helps guide the trustees in exercising their discretionary powers.

Taxation:

Discretionary trusts are subject to a more complex tax regime, including charges on gifts into the trust and taxes on trust income and gains.

Inheritance Tax (IHT) on Creation of Trust

Lifetime Gifts into Discretionary Trusts

Lifetime gifts into discretionary trusts are considered chargeable lifetime transfers (CLTs) and are subject to IHT at the lifetime rate of 20% on the amount above the settlor’s nil rate band. However, discretionary will trusts are not subject to the 20% lifetime tax, as the estate pays the IHT at the death rate of 40% on amounts exceeding the available nil rate band.

Grossing Up the Tax

If the settlor pays the tax, it is considered a further gift, and the tax must be grossed up to value the ‘loss’ to the estate. This results in an effective rate of 25%. The nil rate band available to the settlor is reduced by the value of any other chargeable transfers made within the preceding seven years, with potentially exempt transfers ignored.

Annual Exemption

The settlor’s annual exemption can cover up to £3,000 per settlor and be applied to a larger gift. 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.

Normal Expenditure from Income Exemption

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

Business and Agricultural Relief

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

Tax Payable on Death within Seven Years

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%, with potentially exempt transfers that become chargeable because they were made within seven years of the settlor’s death taken into account. There is a reduction in the amount of tax payable if death occurs after three but before seven years, 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.

Removal of Business and Agricultural Relief

Business and agricultural relief given when assets were transferred into the trust may be removed if the trustees no longer hold the asset or 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, there may be additional IHT due on the settlor’s death within seven years.

10-Year Periodic Charge

Discretionary trusts are considered ‘relevant property’ and are subject to IHT assessment every ten years, known as the ‘periodic’ or ‘principal’ charge. On each 10-year anniversary, the trust is taxed on the value of the trust less the nil rate band available to the trust, with the rate on the excess being 6% (calculated as 30% of the lifetime rate, currently 20%). If the trust value is less than the nil rate band, there will be no charge.

Additions to Trusts

If property is added to a trust between 10-year anniversaries, it will be included in the value on the periodic charge date, but the “actual rate” applying to those assets must be adjusted. Calculating this adjustment involves multiplying the actual rate by (40 – X), where X is the number of complete three-month periods between the creation or last 10-year anniversary and the date of the addition. Trustees should therefore keep accurate records of additions and their investments.

These rules also apply to assets in trusts that receive regular payments through the normal expenditure out of income exemption. However, this exemption may reduce Inheritance Tax (IHT) for the settlor, but it is not relevant for the calculation of 10-year IHT charges, which should be based on the value of the assets to the trustees.

IHT on Distributions of Capital from Trusts (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 determined by the following:

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

In both cases, the rate is then apportioned based on the number of three-month periods that have elapsed since the last 10-year anniversary or inception of the trust.

As a general rule, no IHT is due on distributions made in the first ten years if no tax was due on the creation of the trust. However, there may be exceptions, such as:

• The settlor dies within seven years of an earlier Potential Exempt Transfer (PET)
• An exemption was used to reduce the settlor’s IHT, as exit charges are based on the value to the trustees
• An asset that previously qualified for 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, and periodic and exit charges are only calculated using the standard nil rate band.
• A special rule applies in the case of a discretionary will trust, where no IHT exit charge is applied to distributions within two years of the settlor’s death, and it is treated for IHT purposes as if it were made by the deceased at the time of their death.

Helpful Accountants for Trusts

The taxation of discretionary trusts can be complex, and it is important to know the various rules and regulations. Understanding the tax rates, the process of grossing up, and the tax pool are crucial elements in ensuring that the trust is tax-efficient. It is also essential to be aware of the tax implications for both the trustees and the beneficiaries of the trust. If you need further assistance or have any questions, please don’t hesitate to contact us.