Discretionary Trust, Wills & Inheritance Tax

Using the very simple method of including provision for a discretionary trust in your will, you could save up to £114,000 in inheritance tax

What is a discretionary trust?

A discretionary trust is a very flexible type of trust. The trustees of the trust own the trust's property on behalf of the beneficiaries. The beneficiaries need not all even be born at the time the trust is created.

The trustees can pay out income or capital to any one or more of the beneficiaries entirely at their own discretion. No beneficiary has a right to demand income from a discretionary trust.

Why include one in your will?

There are good planning reasons why a discretionary trust is beneficial and a substantial amount of inheritance tax may be saved.

The first slice of any individual's estate, including gifts which they have made in the last seven years, is generally free of inheritance tax. This slice, referred to as the 'nil rate band', was increased to £285,000 from 6 April 2006. Inheritance tax is charged at 40% on the amount which exceeds the nil rate band.

The nil rate band is often wasted by married couples on the death of the first spouse.

Many couples choose to leave all of their estates to the surviving spouse on the first death, eg "I leave all of my estate to my wife provided that she survives me...". This may be to ensure that the surviving spouse has sufficient assets for the rest of his or her life - or simply because it is perceived to be the "done thing".

Transfers between spouses including transfers on death are exempt from inheritance tax (subject to a limit of £55,000 if the surviving spouse is not domiciled in the UK). This should also extend to civil partners once the legislation relating to taxation is enacted. Thus, there is no tax to pay when the first spouse from a marriage dies if all of that spouse's assets are left to the survivor. However, the combined estate is then taxed when the survivor dies.

Where all of the estate is left to the surviving spouse, the deceased's nil rate band is not used, except to the extent that the individual made certain gifts during his or her lifetime. Currently an extra tax charge of £114,000, on the death of the survivor, could be saved if the nil rate band is used.

It is therefore far more tax effective to use up the nil rate band of both spouses by creating a discretionary trust in the will. This kind of trust is called a 'nil rate band discretionary trust'.

How do I provide for the survivor?

The surviving spouse can be included as one of the beneficiaries of the trust. The trustees can be empowered to pay out income or the underlying capital to the surviving spouse at their discretion. Thus the surviving spouse can enjoy both the income and capital of the trust. However, with this kind of trust (unlike life interest trusts) the capital is not added to the estate of the surviving spouse on his or her death and is not charged to inheritance tax on that occasion.

How do you guide the trustees?

This is usually achieved by leaving a 'letter of wishes' with the will. Such letters are quite usual and are read alongside the will, though they are not binding on the trustees. It is quite normal for such a letter to state that the first aim for the trust is to ensure adequate provision is made for the surviving spouse for the remainder of his or her days. The letter will usually say what is desired to happen thereafter, such as passing assets to the children.

How does the trust operate?

The executors will pass the assets which are to be the trust property to the trustees. Very often, the trustees are the same people as the executors. In this case, they simply own the property as trustees as opposed to holding it as executors.

The trustees will then need to register the trust with HM Revenue & Customs (HMRC) who will send a short form for the trustees to complete. This enables HMRC to register the trust.

Is the trust subject to tax in the normal way?

Yes, the trustees are subject to income and capital gains tax in the same way as individuals. After a deduction for the trust's management expenses, the trust income is taxed at 40% (32.5% for dividends). In addition, capital gains are also taxed at a flat rate of 40% after deducting the trustees' annual exemption which is, at most, half that of an individual.

The trustees will receive a tax return in exactly the same way as an individual. The filing deadlines and the dates for the payment of tax are exactly the same as for individuals.

Distributions of income to beneficiaries, including the surviving spouse, will suffer income tax in the hands of the beneficiary but with a credit for the tax paid by the trustees. To the extent that the tax paid by the trustees exceeds the income tax liability arising to the beneficiary on such income, a tax refund will be made to the beneficiary.

Capital can be appointed to beneficiaries tax free in all but exceptional circumstances.

A discretionary trust is subject to inheritance tax every 10 years after the creation of the trust. The rate at which the tax is paid at current rates is not more than 6% of the market value of the trust's assets at the time of the charge and a nil rate discretionary trust will often escape tax altogether.

There is also a charge when assets cease to be held on discretionary trust, eg if assets pass out of trust to a beneficiary. In this case, the charge to inheritance tax is based on:

• the value of the property leaving the trust
• the proportion of the period of 10 years for which the assets have been held on discretionary trust since the last 10 year charge
• the rate of tax at the last 10 yearly charge

but subject to any inheritance tax reliefs available at the time.

Who should I nominate as trustees?

This is a very personal decision. Essentially, you will probably want to choose trusted family members or close friends. You should check that the people you nominate are willing to act for you. You might also wish to include a professional trustee, though this may be dependent on the complexity of your affairs.

Trusts and wills are often written on very flexible terms allowing trustees greater discretion in their management. The increasing complexity of modern trust and tax law as well as the reluctance of many people to become involved in decisions that require not only a professional competence but also an independent detachment from family dynamics means that an independent trust company may be the best choice - especially as the trust company is always there and doesn't die, retire or take holidays. Grant Thornton Trust Company Limited was incorporated as a wholly-owned subsidiary of Grant Thornton UK LLP to act as trustee and executor working alongside your usual Grant Thornton contact.

What sort of property should be included in the trust?

In many instances, it will not matter what property is included in the trust. However, where a person holds business or agricultural property, significant tax advantages can be obtained in structuring legacies between the trust and a surviving spouse and further tax planning advice should be sought. Further advice should also be sought where all or part of the nil rate band legacy will need to be satisfied by a transfer of the family home, as additional structuring will be required to ensure that the planning remains effective.

What other matters should I consider?

This factsheet summarises the legal position in England and Wales. Different legislation may apply in Scotland, Northern Ireland and other jurisdictions.

It is important that you understand the implications of making a will that includes a nil rate band discretionary trust. You need to understand what the particular inheritance tax implications are of you owning a particular piece of property. You should ensure that all areas are considered so that your trustees will administer the trust in accordance with your wishes and instructions.

Drafting of the clauses can be critical to ensure that no unexpected tax charges arise.

It is important to review your will everyfew years to take account of changing circumstances and relationships. Apart from these regular reviews, it is essential to reconsider your intended bequests after separation or divorce. Furthermore, remarriage generally revokes an existing will in its entirety, which may leave children of the former marriage without any claim on your estate.

Who should I contact?

Grant Thornton offices and staff are well equipped to advise you on wills, estate and tax planning issues and how to administer trusts. If you would like advice on any of the points covered in this factsheet please contact the person at Grant Thornton who normally advises you or the local office below.