Discretionary
or Flexible Trust

• Discretionary trusts may be created during lifetime or on death. They are typically used where the settlor wishes the trustees to have maximum control over who will benefit and when. The settlor may provide the trustees with an expression of wishes that can guide them in how to exercise their discretionary powers. It is important to note that this would not be a legally binding document but can provide clear guidance to the trustees.
• This level of control and flexibility comes at a price of a heavy tax regime than some other types of trusts. Discretionary trusts are subject to the IHT relevant property regime. Gifts into them are chargeable transfers and the trust may be subject to periodic and exit charges. Trust income and gains are subject to the trust rates of tax.
• Married couples use Discretionary will trusts to take advantage of the nil rate bands. On first death, an amount up to the nil rate band was put in trust for which the survivor was also deemed a beneficiary; the balance of the estate then passes IHT free to the beneficiary that is alive. 
• Reasons for using a Discretionary will could also include: control, flexibility and asset protection.

If property is added to a trust between 10 year anniversaries, these will already be included in the value on the periodic charge date.

But because these assets have not been relevant property for the full 10 year period, the ‘actual rate’ applying to those assets will need to be adjusted.

The adjustment made is to multiply 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.

It's therefore important for trustees to keep good records of when additions are made and how they're invested.   

Where regular payments have been made using the normal expenditure out of income exemption, these addition rules will apply to the assets in trust.

While the expenditure out of income exemption can reduce IHT for the settlor, it is irrelevant for the calculation of 10 year IHT charges which should be based on the value of the assets to the trustees. 

The income tax rate is taken in two ways:

• The 1st £1,000 of the trust income is taxed at the standard rate.
• Anything over this is taxed at the trust rate.
• The trust rate is equal to the additional rate for individuals.

Any income that is distributed to a beneficiary will be paid net with a certificate (R185) showing the tax accounted for by the trustees at 45% (the tax credit).

The beneficiary will be liable to tax at their own marginal rate on the gross distribution, but if this is more than the tax credit, some or all of the tax credit can be reclaimed.

Lifetime gifts of existing assets into trust, other than gifts of cash or the assignment of investment bonds, will be disposals for CGT.

Any gains will be assessed on the settlor unless they elect to ‘holdover’ the gain. This election effectively postpones the taxation of the gain until the trustees sell the assets or transfer them to a beneficiary. Holdover is available because the transfer to trust is also a chargeable transfer for IHT.

Holdover relief is not available where the settlor, their spouse/civil partner or their minor (under18) unmarried child can benefit from the trust (these are known as 'settlor interested' trusts).

Assets transferred to trust on the settlor’s death won't normally have been subject to CGT. The trustees will have acquired the assets at their market value at the date of death.

The trustees are the legal owners of any trust assets and investments. All the powers a trustee has must be used in the best interests of the beneficiaries.

Discretionary trusts will need to be entered on the HMRC trust register if they have income or capital gains.

A trust tax return needs to be completed by the trustees every year that there is trust income or gains. Investment bonds may therefore appeal as a trust investment because they are non-income producing and can simplify tax reporting requirements.