What are Discretionary Trusts?

How they can be used and their tax implications

Discretionary trusts, commonly referred to by some as ‘trust funds’, have often been used in the past as a way for wealthier families to keep money, investments and assets within the family for future generations.

But the flexible nature of such trusts means that, far from being a vehicle solely for the rich and famous, discretionary trusts can provide an effective option for anyone looking to provide future support for children or other beneficiaries, as and when it’s most appropriate.

What does a discretionary trust allow you to do?

The structure of a discretionary trust enables you, as the person putting your assets or money into the trust (known as the settlor), to give those assets to a group of people chosen by you (the trustees) to look after. As the settlor, you may appoint yourself as a trustee.

The trust deed will also name the group of people who you want to eventually benefit from those assets (the beneficiaries). Although it will be at the discretion of the trustees to decide which of the beneficiaries to pass assets on to, when, and how much each will receive, you can indicate to the trustees how you would like them to exercise their discretion. So while your wishes are not legally binding on them, they will often take them into consideration.

The assets are ‘held in trust’ for the beneficiaries and, along with any payments received from them, make up the trust fund. The assets no longer belong to the settlor, nor do they automatically belong to the beneficiaries.

Why is a discretionary trust a solution to a range of situations?

Discretionary trusts can be used to make gifts either during your lifetime or after your death. As well as being flexible, they have proved a popular method of estate planning because assets remain outside the beneficiaries’ estates for Inheritance tax purposes, and are not included in any calculation for means-tested benefits.

Also, while providing your children and grandchildren with continuing financial support after your death is probably the most common reason for setting up a discretionary trust, there are other circumstances which may prompt a settlor to opt for this more flexible option.

You can remain in control

You may wish to gift cash, property or any other asset to your beneficiaries. If, however, you would like to keep control of how the asset is used, then you would be able to do so by being a trustee. Whilst extracting the asset from your estate and allowing your beneficiaries to enjoy it, jointly with the other trustees you still retain decision making power until transferred to the beneficiaries absolutely.

It provides you with divorce asset protection

If a beneficiary is going through a divorce, an appropriate discretionary trust can ensure that assets from your estate won’t pass to their former spouse.

It enables you to support vulnerable beneficiaries

If a beneficiary has a disability or is vulnerable in some way, or receives other state benefits, then any money paid directly from your estate may merely reduce their entitlement to state support, rather than being of any benefit to them personally. A trust for a vulnerable person can benefit from favourable tax treatment.

It can provide some protection against bankruptcy

Similarly to the divorce settlement, if a beneficiary is bankrupt, or in danger of becoming bankrupt, there is a real risk that with no discretionary trust in place, any gift from your estate could be paid directly to the beneficiary’s creditors.

So there are a range of situations where a discretionary trust could provide an ideal solution, but it’s important to recognise the tax burdens associated with discretionary trusts, and also to consider whether other planning options would be more tax effective.

A trust is a separate legal entity and transfer of assets into the trust may come with a tax cost.

What are the tax implications and opportunities associated with discretionary trusts?

Income tax

A discretionary trust will always pay Income tax at the highest rate. For example, any gross income above £500 (the allowance for trusts) is taxable at the current trust tax rate of 45%; the exception to this is dividends, where the tax rate is 39.35%. When trustees pay income to a beneficiary who is taxed at less than 45%, the beneficiary can reclaim tax so that their eventual tax burden is no greater than it would have been if the trust assets were their own.

Trusts can therefore prove a useful tool for Income tax planning, particularly where say a grandparent or distant relative wishes to provide income to minor children who may not otherwise have any income of their own. Trust income may be a means of using their allowance and allowing them to reclaim the tax paid by the trustees in part or in full. Where the beneficiaries can entirely reclaim the tax paid by the trustees, this makes the effective overall tax rate on the income 0%.

Capital Gains tax

There will also be Capital Gains tax to pay at a rate of 24% (or 28% for carried interest) if the trust’s annual total taxable gain is greater than its tax-free allowance (currently £1,500, or £3,000 if the beneficiary is vulnerable).

Inheritance tax

Trustees are subject to Inheritance tax (IHT) in their own right, under what are commonly known as periodic charges. Commonly these are less expensive, and more manageable from a cashflow perspective, than the IHT that would otherwise arise on the death of the settlor with the current rate of IHT at 40% on death.

There is a 10-year charge (currently up to 6%, payable on the amount by which the value of the trust fund exceeds the available nil rate band). There are also exit charges where capital is distributed from the trust to a beneficiary and these are generally a proportion of the 6% charge, depending on how much time has passed since the last 10-year charge.

There may also be Inheritance tax (IHT) implications if the value of the assets put into trust by the settlor exceeds the £325,000 IHT nil rate band. Trusts are often formed as part of an Inheritance tax planning exercise and bespoke advice is often needed before a person settles cash or assets into a new trust. Where the asset qualifies for relief, such as Business Property Relief, then it may be that no IHT arises on the initial transfer. This position may change under the proposed reforms to IHT taking effect from April 2026.

Finally, trustees of existing settlements should be aware of the need to comply with the HM Revenue & Customs Trust Registration Service. This is a central register that HMRC maintains of most trust arrangements, particularly express trusts (i.e. those created intentionally by the settlor). Registration is often required even if the trust has no tax to pay at the time it is created.

So, while you don’t have to be wealthy to find that a discretionary trust can offer a flexible, effective way of passing assets onto your chosen beneficiaries – both during your lifetime, and following your death – there may be other options, including alternative trusts, which could be more appropriate for your individual situation.

The key issues is to seek expert advice as early as possible, and make sure that any changes in your own personal situation – or your wishes about how you continue to support loved ones – are reflected in your long-term tax and estate planning.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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