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What is a discretionary trust?

In a discretionary trust, the trustees are the legal owners of any assets - such as money, land or buildings - held in the trust. These assets are known as 'trust property'. The trustees are responsible for running the trust for the benefit of the beneficiaries.

The trustees have 'discretion' about how to use the trust’s income. They may also have discretion about how to distribute the trust’s capital. The trustees may also be able to 'accumulate' income - add it to capital. See the section below on accumulation trusts.

Trustees may be able to decide:

• how much income and or capital is paid out, if any
• which beneficiary to make payments to
• how often the payments are made
• what, if any, conditions to impose on the recipients
  

Discretionary trusts are sometimes set up to put capital aside for:

• a future need that may not be known yet, for example a grandchild that may require more financial assistance than other beneficiaries at some point in their life
• beneficiaries who are perhaps not capable or responsible enough to deal with money by
  themselves

Under the terms of the deed that creates the trust, there may be situations when the trustees have to use income for the benefit of particular beneficiaries. However, they may still retain discretion about how and when to pay. The extent of the trustees’ discretion depends on the terms of the trust deed.

Example

Mina puts money into trust, to be held in trust for twenty years for the benefit of her two ten-year-old grandchildren. The trustees can decide how to invest or use the money and any interest it earns to benefit the grandchildren. So, when the children are young, the trustees might decide to pay for piano lessons for them. As they get older, the trustees might pay towards a wedding.

Accumulation trusts

In an accumulation trust, the trustees can accumulate income within the trust, that is add it to the trust capital. They will often do so until the beneficiary becomes legally entitled to the trust assets (such as money, land or buildings) or the income produced from the assets. Income that has been ‘accumulated’ becomes part of the capital of the trust. The trustees may also pay income at their discretion.

Accumulation trusts should not be confused with ‘accumulation and maintenance trusts’. Accumulation and maintenance trusts are a type of trust that qualified for favourable Inheritance Tax treatment. The Finance Act 2006 ended this treatment and made provisions so that accumulation and maintenance trusts became either ‘18 to 25 trusts’ or were moved into the new ‘relevant property’ trusts. Find out more about these types of trust by following the link below.

• Trusts that do and don't pay Inheritance Tax

Discretionary or accumulation trusts and Income Tax

Trustees are responsible for declaring and paying Income Tax on income received by the trust. They do this on form SA900 Trust and Estate Tax Return each year.

In both discretionary trusts and accumulation trusts income is taxed at the special trust rates, apart from the first £1,000 of trust income, which is known as the ‘standard rate band’. Income that falls within the standard rate band is taxed at lower rates, depending on the nature of the income - as shown in the tables below.

However, if the person who put the assets into the trust (the settlor) has more than one trust, the £1,000 standard rate band is divided by the number of trusts they have. If the settlor has more than five trusts, the standard rate band is £200 for each trust.

Trust income up to £1000

Trust income over £1000

Special rules apply to trusts with vulnerable beneficiaries - see the section on vulnerable beneficiaries below.

Some items that are capital in trust law are treated as income for tax purposes when received by trusts. They're taxed at the trust rate (50 per cent) or the dividend trust rate (42.5 per cent), depending on the type of item.

This is a complicated area of trust taxation. You can find out more about capital items that are treated as income in HM Revenue & Customs' technical guidance - Trusts, Settlements and Estates Manual.

• Capital items that are income for tax purposes - detailed guidance Opens new window

• Get help completing the Trust and Estate Tax Return

• More about tax on different kinds of trust income

Discretionary income payments to beneficiaries

When trustees make a discretionary payment of income it carries a tax credit at the trust rate (currently 50 per cent). This means it is treated in the hands of the beneficiary as if Income Tax has been already paid at 50 per cent. The beneficiary might be able to claim some or all of the tax back if they're a non-taxpayer or a 20 or 40 per cent taxpayer.

Trustees of a discretionary trust - or an accumulation trust where they also have the power to make discretionary payments - need to make sure that they've paid enough tax to cover the tax credit given to the beneficiary. They do this using a process called the ‘tax pool’, which keeps a record of all discretionary income payments made by the trustees, and the tax the trustees have paid.

Different rules apply for payments to beneficiaries of settlor interested discretionary trusts. Follow the link below to find out more.

• Beneficiaries: paying and reclaiming tax on trusts

• Tax pool and help with tax pool calculations

Discretionary or accumulation trusts and Capital Gains Tax

Capital Gains Tax is a tax on the gain in the value of assets such as shares, land or buildings. A trust may have to pay Capital Gains Tax if assets are sold, given away or exchanged (disposed of) and they’ve gone up in value since being put into trust. The trust will only have to pay the tax if the assets have increased in value above a certain allowance known as the 'annual exempt amount'. Trustees are responsible for paying any Capital Gains Tax due.

Beneficiaries aren't taxed on any trust gains and don't get credit for any tax paid by the trustees.

• Trusts and Capital Gains Tax

Discretionary or accumulation trusts and Inheritance Tax

There may be an Inheritance Tax charge when:

• assets are put into a discretionary trust
• a discretionary trust reaches a ten-year anniversary
• assets are taken out of a discretionary trust or the trust ceases
  

Sometimes Inheritance Tax uses different terminology for trusts. Discretionary trusts may fall within what are known as ‘relevant property’ trusts.

• Trusts and Inheritance Tax

Discretionary or accumulation trusts with vulnerable beneficiaries

A discretionary or an accumulation trust may be used to help a ‘vulnerable beneficiary’. A vulnerable beneficiary is someone who is:

• mentally or physically disabled
• a child below the age of 18 who has lost a parent through death
  

A trust set up for the benefit of a vulnerable beneficiary may qualify for special tax treatment.

• Trusts for vulnerable people

Useful contacts

• HMRC Trusts & Estates