What is a Discretionary Trust?
A Discretionary Trust is a type of trust where the shares or benefits distributed to each beneficiary are not predetermined or fixed by the settlor (the person who creates the trust) in the trust deed. Instead, the trustees (those who manage the trust) or another appointed person have the discretion to decide how the trust’s income or capital will be distributed among the beneficiaries. This flexibility is particularly useful when the needs of the beneficiaries are likely to change over time, such as in the case of minor children or beneficiaries with unpredictable financial needs.
Key Features:
- Flexibility: The trustees have the discretion to vary the distribution of income or capital among the beneficiaries.
- Changing Needs: Suitable for scenarios where beneficiaries’ needs may change over time.
- Tax Benefits: Historically used to mitigate inheritance tax liabilities, though regulations have evolved over time.
Examples of Discretionary Trusts:
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Family Trust:
- Set up by parents or grandparents for the benefit of their children or grandchildren. Trustees can decide to provide more income to a beneficiary who needs financial assistance due to education, health issues, or other reasons.
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Charitable Trust:
- Established to distribute funds to various charities at the discretion of the trustees. Allows flexibility in supporting different charitable causes over time.
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Employee Benefit Trust:
- Created by a company for the benefit of its employees. Trustees have the discretion to award bonuses or benefits based on performance and company profitability.
Frequently Asked Questions (FAQs):
Q1: Who can be the beneficiaries of a Discretionary Trust?
A1: The beneficiaries can be individuals, family members, or even organizations like charities. The settlor defines the class of beneficiaries when creating the trust deed.
Q2: What are the powers of the trustees in a Discretionary Trust?
A2: Trustees have the power to decide how much income or capital each beneficiary receives, and they must act in accordance with the trust deed and in the best interests of the beneficiaries.
Q3: Are Discretionary Trusts subject to inheritance tax?
A3: Yes, discretionary trusts are typically subject to inheritance tax rules. Since April 2008, many forms of trusts were reclassified affecting their tax advantages.
Q4: Can beneficiaries challenge the trustees’ decisions in a Discretionary Trust?
A4: Beneficiaries can challenge trustees’ decisions if they believe the trustees are not acting in accordance with the trust deed or their fiduciary duties. Legal advice should be sought in such cases.
Q5: How are income and gains taxed in Discretionary Trusts?
A5: Income and capital gains within a Discretionary Trust may be subject to different tax rates compared to individual beneficiaries and differ depending on jurisdiction.
- Trust: A fiduciary relationship in which one party, known as a trustee, holds legal title to property for the benefit of another party, the beneficiary.
- Accumulation and Maintenance (A & M) Trusts: Trusts where income is accumulated and not immediately distributed to the beneficiaries, particularly for young minors’ future use.
- Relevant Property Trusts: Trusts subject to specific tax regimes, including inheritance tax regulations.
- Investment Trust: A form of trust where managers have discretion over investments, distributing returns to the beneficiaries or reinvesting them.
Online References:
Suggested Books for Further Studies:
- “Trusts and Equity” by Richard Edwards and Nigel Stockwell
- “Trusts Law: Text and Materials” by Graham Moffat
- “Drafting Trusts and Will Trusts: A Modern Approach” by James Kessler QC and Charlotte Ford
- “The Law of Trusts and Trustees” by Geraint Thomas and Alastair Hudson
Accounting Basics: “Discretionary Trust” Fundamentals Quiz
### Who can alter the distribution of income in a Discretionary Trust?
- [ ] Beneficiaries
- [x] Trustees
- [ ] Settlor after creation
- [ ] Government authorities
> **Explanation:** In a Discretionary Trust, the trustees have the discretion to alter the distribution of income and capital among the beneficiaries based on their needs and the trust deed's guidelines.
### What is a primary advantage of a Discretionary Trust?
- [ ] Fixed income for beneficiaries
- [x] Flexibility to adapt to changing needs
- [ ] Guaranteed tax exemption
- [ ] Beneficiary control over assets
> **Explanation:** A primary advantage of a Discretionary Trust is its flexibility to adapt the distribution of income and capital to the changing needs of the beneficiaries.
### Are the shares of each beneficiary fixed in a Discretionary Trust?
- [ ] Yes, the shares are fixed by the settlor.
- [x] No, the shares can be varied at the trustees' discretion.
- [ ] Only after a certain period.
- [ ] Depending on the amount of trust capital.
> **Explanation:** The shares of each beneficiary in a Discretionary Trust are not fixed and can be varied at the discretion of the trustees or another appointed person.
### How has the classification of many Discretionary Trusts changed since April 2008 in the UK?
- [ ] No change has occurred.
- [ ] All were abolished.
- [x] Reclassified as 18-25 trusts or relevant property trusts.
- [ ] Converted to fixed trusts.
> **Explanation:** Since April 2008, many Discretionary Trusts in the UK were reclassified as either 18-25 trusts or relevant property trusts, affecting their tax treatment.
### Which of the following is a use case of a Discretionary Trust?
- [x] Family trusts to provide for children’s future needs.
- [ ] Creating a specific inheritance for one beneficiary.
- [ ] Eliminating the need for trustees.
- [ ] Directing investments without any flexibility.
> **Explanation:** Discretionary Trusts are often used in family trusts to provide for the changing future needs of children or other beneficiaries.
### In a Discretionary Trust, who primarily benefits from the trustee's decisions?
- [ ] Only the settlor.
- [ ] Set beneficiaries equally.
- [ ] One primary beneficiary.
- [x] Any or all beneficiaries as suited by their needs.
> **Explanation:** The trustees' decisions in a Discretionary Trust primarily benefit any or all the beneficiaries as suited by their changing needs and circumstances.
### What was a historical tax benefit of Discretionary Trusts before law changes?
- [x] Used to avoid inheritance tax liability.
- [ ] Provided higher interest rates.
- [ ] Direct tax exemption for trustees.
- [ ] Income tax reduction for settlors.
> **Explanation:** Historically, Discretionary Trusts were used to avoid inheritance tax liability, though such benefits have been diminished by subsequent legal reforms.
### What type of trust did many Discretionary Trusts conform to before being reclassified in the UK?
- [ ] Fixed Trusts
- [x] Accumulation and Maintenance (A&M) Trusts
- [ ] Charitable Trusts
- [ ] Statutory Trusts
> **Explanation:** Many Discretionary Trusts were formerly Accumulation and Maintenance (A&M) Trusts, where income could be accumulated rather than immediately distributed to beneficiaries.
### Can trustees be beneficiaries of the same Discretionary Trust?
- [ ] No, trustees and beneficiaries must be different.
- [x] Yes, but they must act in the best interest of other beneficiaries.
- [ ] Only if approved by the settlor.
- [ ] Trustees are never allowed to be beneficiaries.
> **Explanation:** Trustees can also be beneficiaries of the same Discretionary Trust, but they must always act in accordance with their fiduciary duties and in the best interest of all beneficiaries.
### What determines whether a trust is discretionary?
- [ ] The specific inclusion of 'discretionary' in the trust deed.
- [ ] The value of the trust assets.
- [x] The flexibility given to trustees in managing and distributing trust assets.
- [ ] The identity and roles of the beneficiaries.
> **Explanation:** A trust is considered discretionary if the trustees are given the flexibility to manage and vary the distribution of trust assets among the beneficiaries, as opposed to predefined fixed distributions.
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