Are discretionary trusts still a tax-efficient option?

There are many ways to provide for your family’s long-term financial needs but are UK-based discretionary trusts still a tax-efficient option in wills, as trusts for children and for inheritance tax planning?

Numerous changes in tax legislation in recent years have left many people questioning whether discretionary trusts are still appropriate for them. Despite concerns, discretionary trusts remain helpful in providing for the family's long-term financial needs.

But there are other considerations and here we compare discretionary or accumulation trusts, which usually give the trustee ‘discretion’ on how to use trust income and capital, with ‘interest in possession’ trusts, where the beneficiaries are entitled to trust income as it arises.

When are discretionary trusts still useful?

Providing for the family

Discretionary trusts are the most flexible form of trust for providing for family and loved ones, letting you establish a trust for a group of beneficiaries. The trust deed usually allows the income and capital to be distributed at the trustees' discretion – or the trust income can be accumulated within the trust. Normally the settlor and his or her spouse are excluded under the terms of the trust to avoid the trust income from being taxed on the settlor

This creates flexibility when settling funds on trust for inheritance tax (IHT) planning purposes. Comparatively, an interest in possession trust would require that the trust income be paid out to one or more beneficiaries specified under the trust deed, which is less flexible.

IHT planning

Discretionary trusts are still popular in IHT planning as the lifetime nil rate band, currently £325,000, can be settled on trust without a lifetime inheritance tax charge. Also, assets that qualify for 100% business or agricultural property can be settled on trust in most situations without a lifetime inheritance tax charge. Provided the settlor has not retained an interest under the terms of the trust, the property settled will not be treated as being included in anyone's estate. As they offer much flexibility, they continue to be a useful tool in estate planning.

New interest in possession trusts offer the same IHT benefits as discretionary trusts, albeit they offer less immediate flexibility on the distribution of trust income. 

Minor children

Discretionary trusts are practical where minor children are the beneficiaries of the trust. This is because the trust income can be left on trust to accumulate when the children are too young to receive the money. Once the children are older, trust income can be distributed to them, for example, to pay for their education.

In comparison, interest in possession trusts are less suitable for minors, as the income must be distributed to them. Care must be taken when parents set up trusts for their minor children, as in many cases the income will become taxable on the parents.

When are discretionary trusts less useful?

Is the use of discretionary trusts declining? Yes, in some situations, for example in wills or where an interest in possession trust is more appropriate.

Discretionary trusts in wills

The use of discretionary trusts in wills to use the lifetime nil rate band is declining. This is because married couples and couples in civil partnerships have been able to leave their nil rate band to their partner since October 2007.

Flexible interest in possession trusts

It’s becoming more popular to establish flexible interest in possession trusts. This is because interest in possession trusts are taxed at 20% for most income and effectively 0% for dividends. In comparison, discretionary trusts are taxed at 45% on most income and effectively 30.55% on dividends.

However, if the discretionary trust pays the income to the beneficiary, and the beneficiary is taxed at lower tax rates, they will be able to make a repayment claim. The way that this works means a beneficiary will lose out where dividend income is received by the trustees as compared to the position had he or she held the shares directly. This is because as a beneficiary they cannot benefit from the 10% tax withheld in relation to a dividend payment received by the trustees. Typically, it can be more efficient to opt for an interest in possession trust rather than a discretionary trust.

However circumstances will vary and an interest in possession trust may not necessarily save tax overall, as the income from an interest in possession trust is also taxable on the beneficiary, with a tax credit being provided for the tax paid by the trust.

Looking forward

Discretionary trusts still have their place in making provision for the family and loved ones. They can also be useful in IHT planning. However, discretionary trusts should be compared with alternatives such as interest in possession trusts.

Before setting up or changing a trust structure, you should always seek professional advice. If you would like to talk to someone about tax issues and trusts, please get in touch.

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