Some pros and cons of Lifetime Discretionary Trusts

Date Added: 30 July 2012

Listed below are some of the benefits and disadvantages of lifetime discretionary trusts:

Settlor can transfer assets up to the nil-rate band into the trust every seven years.  The assets will be outside the Settlor’s taxable estate provided he survives seven years, thereby avoiding a 40% IHT charge on death.
Previously, legacies of the entire estate to the spouse used to waste the nil-rate band of the deceased.  This was avoided by transferring up to the nil-rate band into a discretionary trust instead of to the spouse.  Since 9 October 2007 the unused nil-rate band of the first deceased can be carried forward to the spouse on their death, so nil-rate band discretionary trusts no longer carry the same fiscal advantages as they did before.
Trusts’ assets will remain outside the estate of any beneficiaries unless and until assets are actually transferred to them from the trust.
IHT under the “relevant property regime”.
Upfront IHT charge of 20% on gifts into trust above nil-rate band.
10 yearly IHT charge of up to 6% on asset values over nil‑rate band (30% of lifetime IHT rates).  “Exit charges” charged at a proportional rate when assets removed between 10 year anniversaries.
Nil-rate band is replenished every seven years so client could create a new trust every seven years.  If client is married, both spouses can use their own nil-rate band, doubling the amounts that can be put into the fund tax free.
Income tax within Trust – income over £1,000 is taxed either at the dividend trust rate of 42.5% or at the 50% “the Trust Rate” (2012-13 tax year).
Income tax paid by trustees is available as a credit against the tax to which recipient beneficiaries are subject and can be reclaimed by the beneficiary.
Income tax on distribution – but beneficiaries may be able to reclaim tax.
Discretionary trusts are income tax efficient (provided that the income is not from UK company dividends) as the trustees can direct funds to those beneficiaries in the lowest tax bracket.
Distinct disadvantages of trusts where trust receives UK company dividends subject to the dividend trust rate.  If a discretionary trust does receive income from UK company shares, it is best to accumulate that income rather than distribute it immediately, and make capital payments later.
10 yearly IHT charges and exit IHT charges between 10 year anniversaries are relatively modest.
There is also the possibility of setting up several smaller trusts rather than one large one so that the assets in each individual trust will always be below the nil-rate band.  Provided that each trust commences on a different day, they will not be related for IHT purposes.
If client has held any shares in a private trading company for at least two years, the shares are likely to benefit from 100% BPR and be totally exempt from IHT.  In this case, they could be transferred to a lifetime discretionary trust without any IHT.
Where the settler remains a beneficiary, it is regarded as a gift with reservation and the property in the trust will be taxed as part of his estate.  Similarly, where the trust fund includes the settlor’s residence, it is regarded by HMRC as an interest in possession trust and taxed accordingly.
The gifts with reservation provisions are subject to a de minimis rule.  Although, according to HMRC guidance, it is likely that the gift of a holiday home which continued to be used as such by the donor for more than the odd week would be seen as a gift with reservation and taxed accordingly.   This would, however, not be the case if a full market rent was paid for its use.
Regular gifts into trust which are paid as part of normal expenditure out of income, where net income after the gift is enough to maintain the client’s usual standard of living, are exempt from IHT.
(As of 6 April 2008) CGT on capital gains within trusts on sale of assets is at flat rate of 18%.  If the assets stayed in a taxable estate then they could be liable to 40% IHT.
Assets placed into trust during client’s lifetime are not counted as part of estate when it comes to later life care means testing.
CGT – Trusts benefit from an annual exemption of up to £5,300.  CGT on gains are charged in the hands of the trustees (2011-12).
CGT – Trustees are only entitled to half the annual exemption of individuals.
An individual has an annual exemption of £10,600 (2011‑12)
To protect beneficiaries from their own improvidence, prevent the youth from having too much money early on
Settlor retains no absolute entitlement to the interest and capital of the fund.
To prevent the creditors of a beneficiary who goes bankrupt from being able to get at the trust capital or income.
The assets of a discretionary trust cannot include the main residence as that would be a retained benefit.
To maintain flexibility of responses to the changing needs of the different beneficiaries
Discretionary trusts can be inconvenient and disproportionately expensive to administer.
To give trustees maximum discretion over the occupation and use of the land comprised in the trust fund (they avoid s.12 TLATA 1996)
Good if the beneficiary is disabled or otherwise unable to manage their own property
The assets in the trust are protected from any divorce proceedings that the beneficiaries may be involved in
Ease of restructuring – can be altered into an interest in possession or A&M trust if it becomes more appropriate.

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