Financial planning


Discretionary trusts are often used as an important part of estate planning. They can be very tax efficient, assisting with inheritance tax planning or used for specific purposes such as the lifetime provision of income for a child with severe disabilities.

By putting some of your estate in a trust for any number of bona fide reasons, the trustees that you have appointed to look after the funds can distribute income and/or capital at the right time to the beneficiaries you have chosen and in accordance with your wishes.

When first mentioning the option of a trust or trust fund to many clients, it conjures thoughts of ‘Panama papers’ style planning given the media attention received over the years. The tax advantages of trusts have slowly been eroded over time, beginning in 2006 when Gordon Brown announced significant reform to trust legislation and taxation. Previously to this, connotations for the public of trusts were a tax avoidance measure for the ultra-rich.

England and Wales have some of the oldest trust laws in the world. The Crusades of the 12th century sent many nobles abroad for undefined long periods so they would typically hand over their land and property to another individual to look after while away at war – unsurprisingly returning home to a land dispute, often many years later. It was during these land disputes that trust law evolved, starting out from the legal term “use of land” to the trust system that we are now familiar with.

There are a number of different types of trust structures available to UK individuals, including:

  • bare trust
  • interest in possession trust
  • discretionary trust
  • accumulation trusts
  • mixed trusts
  • settlor-interested trusts

Discretionary trusts are often used to reduce the value of the settlor’s estate as part of a wider inheritance tax (IHT) and estate planning strategy. They are a means of providing for beneficiaries without giving them the rights to the trust assets and in the event of the death of the settlor they provide family and loved ones with a degree of financial certainty. These trusts can be set up during your lifetime and can also be written into your Will (discretionary Will trust) although since the introduction of the transferable IHT nil rate band these Will trusts are now less common.

There are a huge number of advantages to utilising a discretionary trust including:

  • ease of distribution of income and capital
  • flexibility over the appointment of trustees and nomination of beneficiaries (see below)
  • control over assets when making gifts, especially when beneficiaries are young, irresponsible or vulnerable
  • privacy for significant family wealth
  • protect assets from risk such as divorce
  • broad range of investment options

Beneficiaries can be named individuals, such as a child with disabilities; a class of people such as “my grandchildren” (whether born or not at the time the trust is established); a charity or other organisations such as sports clubs. For clients who own their own business a discretionary trust can provide a useful structure in which to pass on shares in a family business, thereby offering protection for the benefit of future generations.

This flexible structure with the above advantages sounds perfect when looking to pass wealth on, but as with the yin and yang of the UK’s legislative and tax system, while there is greater flexibility and benefit in one regard, there is generally a disadvantage in the form of taxation associated with it.

There are some further important reasons why these trusts can be tax efficient. In addition to the reduction of the settlor’s estate for IHT purposes, a further IHT benefit can arise by ensuring some assets pass outside of a spouse’s ownership, which in time will mitigate IHT on the second death. In addition, if the beneficiary is in receipt of state benefits, as might be the case where there is a disability, the presence of the trust does not affect the entitlement of the beneficiary to these state benefits.

There are four key taxes that interact with a discretionary trust. A brief overview of each of these is below.

1.         Inheritance tax (IHT)

There are a number of ways in which IHT may be levied on the assets of a discretionary trust. Providing full detail on this is beyond the scope of this article, However in short, there may be IHT:

  • on the way in (entry charge) which occurs when the trust is created and gifts into the trust exceed the nil rate band (for IHT) of £325,000
  • on the ten-year anniversary of the trusts (periodic charge)
  • on the way out (exit charge)

2.         Capital gains tax

A discretionary trust is considered a separate entity and is liable to paying capital gains tax on any gains above the trust’s annual allowance, which is half the allowance an individual benefits from. This is £12,300 for individuals and £6,150 for trusts in the 2021/22 tax year.

The rate of tax levied on capital gains depends on the asset held within trust, with residential property taxed at 28% and other assets such as stocks and shares, taxed at 20%.

3.         Income tax

For the first £1,000 of income received by the trust, dividend income is taxed at 7.5% and all other types of income are taxed at 20%. Beyond this amount, dividend income is taxed at 38.1% and all other income is taxed at 45%

4.         Stamp duty

Discretionary trusts do not benefit from relief on stamp duty, even if the trust is a ‘first time buyer’. Instead, a discretionary trust will generally be liable at the higher rate of stamp duty.

Mattioli Woods is not legal or tax advisers and prior to establishing a discretionary trust it is important to take advice from a specialist solicitor in this area. Trusts need to be registered with the Trust Registration Service and this is a further area where trustees would be wise to seek professional advice to ensure compliance with these new rules.

With the above in mind, discretionary trusts are not the correct solution for every individual or family, and it is important to take professional advice on structuring the trust itself, the tax treatment of the assets held in the trust and also the investment strategy within. Therefore, a joined up approach from your wealth manager, solicitor and accountant is often most effective and prudent.

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