The untimely death of Gerald, 6th Duke of Westminster (the beneficiary of a reputed family fortune of £9 billion, partly comprising prime London property) has been followed by much speculation about the inheritance tax (IHT) that might or might not be payable and analysis of how the family fortune is protected from the ravages of a 40% IHT charge on the death of each Duke.
The final consensus seems to be that the family used a series of discretionary trusts to manage their tax liabilities. So what are discretionary trusts, how can they save tax and can they help people other than the aristocracy?
What is a discretionary trust?
A discretionary trust is a trust under which no beneficiary has a fixed entitlement. There are a range of beneficiaries and any one of them can receive benefits, in the form of capital and/or income from the trust, depending on the decision of the trustees. None of the beneficiaries has a right to receive benefits, just the hope of so doing. Distribution of benefits from the trust is entirely at the trustees’ discretion and the trustees could decide to roll up income rather than distributing it.
How can a discretionary trust save tax?
As no individual has any fixed entitlement under the trust, there is no IHT payable when any one of the beneficiaries dies; instead IHT is payable (at a maximum rate of 6%) on every ten year anniversary of the trust’s creation and when capital leaves the trust (an exit charge). This has the big advantage that there is no large 40% charge at an unknown time in the future but smaller charges at pre-determined dates. If a beneficiary dies prematurely this can be particularly beneficial as the ten yearly IHT charges payable during their lifetime are highly unlikely to equate to the 40% charge that would have been payable had the trust assets been taxed as part of that beneficiary’s estate.
Can discretionary trusts benefit non-aristocrats?
Definitely. The same technique can be employed by anyone whose estate is likely to be liable to IHT. If your Will divides your estate into discretionary trusts for the benefit of each of your children and their families there will also be no charge to IHT on your children’s deaths, but instead the trusts will pay ten yearly and exit charges.
There are also non-tax advantages as the assets in the trust are protected from third party claims, for example, on divorce or bankruptcy, and they cannot be used towards payment of care fees unless the trustees decide that trust assets should be used for this purpose. The money in the trusts forms a “pot” for each branch of the family, with trusted advisers and family members ensuring that the pot is dealt with in a way that reflects your wishes.
Discretionary trusts also have a number of uses in lifetime planning. They can be used, for example, to receive lifetime gifts of cash or assets valued up to the IHT nil rate band (currently £325,000) without any immediate charge to IHT. After a period of seven years has passed from the date of the gift, the assets given to the trust are no longer subject to IHT in your estate, while the use of the discretionary trust, with a range of possible beneficiaries, ensures that flexibility is retained over who benefits from the assets given to it and when. This can be particularly useful if your family is young, not used to dealing with larger sums of money, or if you wish to retain a degree of control over the trust assets.