What is a Discretionary Trust?
A discretionary trust is exactly as it sounds: a trust where the appointment of trust property is at the discretion of the trustees. This means that no beneficiary has a right to receive anything from the trust unless and until the trustee(s) exercise discretion in their favour and make an appointment to them. And once a decision is made out of the trust, the beneficiaries cannot complain as to the nature or size of the bequest – again, this is up to the trustee(s). The main benefit of this discretionary structure is flexibility. When establishing a discretionary trust the settlor (who is creating the trust) doesn’t have to make any decisions up front: they merely need to decide on who might benefit from the trust and list them as potential beneficiaries.
Like all trusts, there is a requirement that the legal ownership of property is separated from the beneficial ownership: property is transferred from the original legal owner (the settlor) to the trustee or trustees of the trust who then hold the legal ownership of the property. In trusts, the beneficial ownership of trust property rests with the beneficiaries (and for a discretionary trust there should be at least two so that the trustees can exercise a discretion). But in a discretionary trust this is only a quasi-proprietary right because the beneficiaries do not actually have any right to any trust property until the trustee(s) make a decision in their favour.
How can you make a Discretionary Trust?
It is possible for a settlor to make a discretionary trust to take effect while they are still alive (this is often given the Latin name “an inter vivos trust”) – the settlor transfers property to a trust to be used for the benefit of someone else. In this circumstance, you would use a trust Deed: this can only currently be created by someone entitled to carry out reserved activities: most usually, this would be a solicitor. A Deed has stringent execution requirements in that it must be in writing, it must be clear on the face of the document that it is intended to be a Deed, and it must be signed by each party to the Deed (so the settlor and all of the trustees), and each signature must be individually witnessed.
A discretionary trust can also be created by will, and in this case, the settlor is referred to as the testator. There are no additional witnessing requirements other than those required to create a will (that the document is clearly a will, and is signed by the testator in the presence of two witnesses, and then they in the testator’s presence).
Creating a discretionary lifetime (inter vivos) trust as estate planning
A trust made by the settlor during his or her lifetime has the advantage of taking property outside of their estate so that when they die that property may be exempt from inheritance tax because the settlor is no longer the owner – the property is legally owned by the trust (which is deemed a fictitious “person” in the eyes of the law). The property may, however, be liable for inheritance tax if the settlor dies within 7 years of transferring property to the discretionary trust: this is to make sure that people do not avoid inheritance tax by transferring their assets into trusts at the end of their life. Discretionary trusts are, however, a useful estate planning tool because they allow testators to take assets that they do not require for their personal use out of their estate and pass them to the next generation without attracting IHT liability so long as they survive the gift by seven years, and sometimes it is even possible to insure against the risk of dying within seven years.
Additionally, discretionary trusts created during the settlor’s lifetime make sure that the intended beneficiaries can be looked after financially should the testator die. There can be some delay between the death of the testator and their executors being granted probate, and until that time, the assets of the estate cannot be distributed. A discretionary trust would allow the trustees to continue to allow the beneficiaries to use the trust property or to distribute funds to them without the need to wait for probate as the trust property no longer forms part of the deceased’s estate.
Other common reasons for creating a discretionary trust
Discretionary trusts are almost inevitably about protection: either protecting assets or protecting people. The following are some common scenarios where a testator (or, in some cases, a settlor) may decide to put a discretionary trust in place:
(a) James has remarried Sarah. He and Sarah each have children from their previous marriages. If he dies, James wishes to allow Sarah to continue to use his estate (to live in the house that they own together as tenants in common and to have access to the funds in their joint account as she currently does). James also wishes that his children are given assistance to start their lives, whether it is to buy a first home, to go to university or to start a business. They are still teenagers, so their future needs are as yet unknowable. And on Sarah’s death, James wishes that his share of the property and his money and other assets are distributed to his children alone, and are not to pass to Sarah’s children.
If James left his estate outright to Sarah, he would be trusting that Sarah would carry out his wishes in providing for his children and leaving his property to them in her will. And there is the risk that if Sarah died without a will, that all of her property would pass automatically under the laws of intestacy which would then include her children (potentially to the exclusion of James’ children). If James left his entire estate in a discretionary trust when he died, making Sarah and his children potential beneficiaries, the trustees would be able to let Sarah continue to live in the family home and give her access to funds while having the flexibility to assess the continuing needs of James’ children as they reached adulthood. And on Sarah’s death, the Trustees could distribute all of the remaining trust property to James’ children as appropriate. To the extent that James had specific guidance to give his trustees (e.g. to try to keep the amounts given to the children roughly equal) he could leave an expression of wishes. This is a letter to the trustees setting out what the testator would like to happen if possible. It is not binding on the trustees, but can give them guidance as to what the testator would have wanted. Most important in this situation is to choose the right trustees who the testator can fully trust to act as he would wish.
(b) Sarah, remarried to James, has two sons, Jeremy and Jason, from her previous marriage. She wishes that James should be given access to the family home, and so she leaves this on a life interest trust for him in her will. She wishes for all of her other assets to be left to her children. However, Jeremy, age 20, has a gambling addiction and, if left a significant sum, would inevitably gamble it away. Sarah wishes for Jeremy to be provided with accommodation and an allowance, but not in a way that would perpetuate his addiction. Jason is only 14 and Sarah wishes that his education is fully completed before he receives his inheritance, but would like him to be provided with a house and a car while he studies.
Sarah’s wishes are quite complex, and while specific trusts could be put into the will with contingencies for each child, a discretionary trust could be a good solution here. Such trusts are often used in situations like this where you have a wastrel beneficiary who cannot be trusted to receive sizable sums of money but need to be provided for, and where the needs of a young beneficiary cannot yet be determined. In putting everything into a discretionary trust, Sarah is allowing her trustees to assess the situation at the relevant time and to make the appropriate decisions for her children (just as she would have done). Again, selecting the right trustee is key, and an expression of wishes in this circumstance would also be of assistance in communicating the types of decisions that Sarah would wish to be made.
(c) Ben has one child, Sophie, who is significantly disabled and is receiving means tested benefits. Ben wishes to leave most of the estate to Sophie, but if he leaves the estate to her outright, this will put her above the benefits threshold. Ben also wishes to give funds towards the education of his niece, Alice, as she requires them.
Ben may decide here to leave everything to discretionary trust for the benefit of Sophie and Alice as potential beneficiaries. Because Sophie would have no property rights under the trust (because it is discretionary), being a potential beneficiary would not push her over the means tested threshold, and also the trustees could assess the needs of Alice and make payments to her as necessary and guided by any expression of wishes. Alternatively, Ben may wish to make a special type of discretionary trust which is available just for vulnerable and disabled persons – this can have special tax advantages, and so might be worth considering for Sophie’s situation. An additional standard discretionary trust could then be established to benefit Sophie and Alice (because there should be at least two potential beneficiaries) to allow for payments to Alice.
(d) Wilma has two children, Alan and Barbara. Alan is married to Isobel, but Wilma does not approve of the match and if Alan died, Wilma would not want Isobel to benefit from any money that Alan had inherited from her. Barbara has only recently got married and intends to start a family. Wilma wishes to make provision for her grandchildren, but otherwise wishes to leave the estate equally between her children.
There is a good deal of uncertainty about Wilma’s situation. At the time of making her will she cannot know how many grandchildren she will have at the time of her death. She also runs the risk that, if she left a portion of her estate outright to Alan, and if he died a short time after her, that property would pass under Alan’s will to Isobel. A discretionary trust would be a good solution here: it is possible to name a class of beneficiaries, for example, my children and grandchildren, so this would include any grandchildren born after the will was created, and indeed after Wilma’s death. As long as the trustees can at any point in time determine whether someone does or does not fall into the defined class, that description can be used to define the class of potential beneficiaries. An expression of wishes could be left to indicate the nature of the benefit that the grandchildren should receive. This form of trust has the additional benefit that the trustees would be able to assess the situation at the time of Wilma’s death to see what was the most appropriate distribution of property. If Alan is ailing and unlikely to live for a long time beyond his mother, it may not be appropriate to make large distributions to him in case such distributions ended up in the hands of Isobel. And if there were significant tax or other advantages at the time of death to leave the property to certain beneficiaries outright, the trustees have the power under s.144 of the Inheritance Tax Act 1984 to restructure the will to make outright gifts as if that had been the testator’s original intention as long as they do so within two years of Wilma’s death.
The above are just some of the many uses of discretionary trusts: their application is varied and can allow almost unlimited flexibility in estate planning. There are, however, tax implications of using trusts and expert tax advice should be sought where necessary.
Written by Sam Warner, Head of Legal Content at Arken.legal.
Arken users who have the right to create Trust documentation can complete a discretionary trust in a fraction of the time with Arken Lifetime, which also includes Interest in Possession Trust (General), Flexible Life Interest Trust, Pension Death Benefit Trust and Charitable Trust. If you would like a demo of Arken Lifetime, please visit www.arken.legal or call 01732 867 792.
