Summary
- A discretionary trust gives trustees flexibility to distribute income and capital among beneficiaries, making it a useful structure for tax planning and asset protection.
- The trustee holds legal ownership of assets, while beneficiaries hold no fixed entitlement until the trustee exercises their discretion.
- Establishing a discretionary trust requires a trust deed, appointment of a trustee, and identification of a class of beneficiaries.
- This is a plain-English guide to discretionary trusts for business owners operating in the United Kingdom.
- The content is produced by LegalVision, a commercial law firm that specialises in advising clients on business structures and trust arrangements.
Tips for Businesses
When setting up a discretionary trust, ensure the trust deed clearly defines the beneficiary class and trustee powers. Review distribution decisions annually with your accountant to optimise tax outcomes. Keep trustee resolutions properly documented, as poor record-keeping can create disputes or compliance issues later.
A discretionary trust splits ownership of property into two parts: trustees hold the legal title and manage the assets, while beneficiaries hold the right to enjoy them. Unlike a fixed trust, trustees decide who benefits and when, making discretionary trusts a flexible tool for estate planning. This article will explain the underlying principles of trust law. It will also explain discretionary trusts and their commercial relevance, particularly in a family business context. Finally, it will explain the process for creating a discretionary trust.
Understanding Trusts
To understand how trusts operate, you first need to understand the law behind property ownership.
1. Beneficial Ownership
Generally, if you own an item of property, you are free to use it as you wish. This includes houses, cars, and money. You will be the ‘beneficial owner’ of the property if you can both:
- enjoy the use of it (e.g. driving a car); and
- dispose of it (e.g. selling a car).
2. Legal and Beneficial Interests
Trusts are sophisticated legal vehicles that take the concept of beneficial ownership and split it into two parts, which are:
- the beneficial interest — i.e. the right to enjoy the property; and
- the legal interest — i.e. the right to dispose of the property.
The settlor will take the property (“trust property”) which he intends to hold “on trust” and do two things with it:
- they will transfer the beneficial interest in the property to one or more people, called the “beneficiaries”; and
- transfer the legal interest (or “the legal title”) to another group of people, called the “trustees.”
3. The Trust
Usually, the trust property will contain a combination of money, shares in companies, and “real property” like land and buildings. The trustees will then have a legal obligation to manage the trust property according to the terms of the trust. A document known as the “trust document” or “trust deed” will detail the terms of the trust.
Additionally, the trustees will need to have the legal title so that they have the authority to manage the property by buying, selling, and reinvesting the property — all ultimately in the interest of the beneficiaries. Having the legal title makes it very easy for the trustees to abuse their position and act in their own interest. So, the law imposes a fiduciary duty on the trustees. This duty ensures that trustees can only ever act in the interests of the trust and the beneficiaries.
The beneficiaries, not having the legal title, do not have the power to dispose of the trust property. This is why trusts are a useful way to ensure that a child or someone incapable of managing their own affairs can still make use of the trust property.
Discretionary Trusts
Discretionary trusts differ from fixed trusts in one critical way. Importantly, the beneficiaries of a discretionary trust do not have an absolute right to enjoy the trust property unless the trustees decide they do.
In practice, this means that you, as the settlor, can nominate a group of beneficiaries but then leave it to the trustees to decide who among them can actually enjoy the benefit of the trust property. This will permit the trustees to consider the personal circumstances of each beneficiary and determine if and by how much they can enjoy the trust property. Therefore, discretionary trusts are more flexible than fixed trusts.
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Discretionary Trusts in a Commercial Context
Suppose you have a family business that you have built yourself over your adult life. Likewise, you are nearing retirement and want to ensure that your business will remain within your family after your retirement and, ultimately, your death.
How Discretionary Trusts Can Help
Creating a discretionary trust gives the trustees the power to exercise their discretion later in the future. They can decide when and how your family members can participate in and enjoy the family business.
Alternatively, trustees of a discretionary trust can determine how to apply the income from the shares (i.e. the dividend payments) to the beneficiaries. For example, suppose you have young grandchildren. Likewise, you want to ensure that their needs are looked after in the future, but you are unsure what these needs will be. According to your grandchildren’s needs, a trustee can decide to apply as much or as little of the dividends.
Like fixed trusts, you can structure discretionary trusts in tax-efficient ways to transfer property so that, for instance, your shares are not subject to substantial inheritance tax.
What Discretionary Trusts Cannot Do
Importantly, a discretionary trust cannot override how a company itself is governed. It is not a substitute for determining how others will run your business after you are no longer in charge.
Therefore, your company should have a succession plan in place before you retire or are no longer capable of managing the company. Skilled solicitors can help ensure that the interests of your company align with your estate planning. For example, having trustees as company directors can be beneficial to ensure they run your business in a way that falls within your family’s best interests.
How to Create a Discretionary Trust
The law requires that all trusts be sufficiently certain. Otherwise, in a dispute, the courts may not be willing to recognise the trust. In such a case, the trust property, including shares in your company, will either:
- revert to you; or
- if you are no longer alive, ownership will pass according to probate and estate laws.
In either case, this may be at odds with your intentions. Therefore, to ensure that your trustees can follow your wishes, it is important to seek the advice of a solicitor when creating a trust.
That said, the actual process of creating a trust is fairly straightforward. You simply need to:
- declare your intention to create a trust;
- ensure that the group of people, such as your family, are sufficiently certain enough to be recognised by the law;
- declare the property that the trust is to hold;
- ensure that you record all the particulars as to how your trustees should manage the trust; and
- nominate the trustees.
This guide outlines how to resolve commercial disputes.
Key Takeaways
Discretionary trusts enable the trustees to choose which beneficiaries can benefit from the trust assets. This is in contrast to a fixed trust, where the settlor clearly sets out each beneficiary’s interests at the point they create the trust. Notably, trusts are more relevant to estate planning than running a business. So, if you own a business and wish for ownership to stay within the family, creating a discretionary trust over the company’s ownership can be an effective way to ensure this. It will also provide for more flexibility in the future, such as on what grounds beneficiaries can enjoy the trust property.
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Frequently Asked Questions
A discretionary trust gives the trustees the power to determine how to apply the trust property in favour of the beneficiaries. They are more flexible than fixed trusts because the trustees can exercise their powers according to the individual circumstances of each beneficiary as the trustee sees fit.
In short, yes, you can. However, be aware that the law holds you to the standards of all other trustees. When you transfer the beneficial interest of the trust property, including your company shares, to the beneficiaries, you must act with their best interests in mind. This means you will no longer have a beneficial interest in the company’s shares. Therefore, as an example, you would not be able to pay yourself the dividends.
No. A discretionary trust cannot override company governance. You still need a separate succession plan to determine how others will manage your business.
Trust property reverts to you or passes according to probate laws, potentially contradicting your intentions.
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