What is Discretionary Trust Taxation?

Full Definition

A discretionary trust is one in which the trustees, rather than any beneficiary automatically, decide how and when trust income and capital are distributed among a defined class of potential beneficiaries, giving considerable flexibility to respond to beneficiaries' changing circumstances over time, such as one beneficiary falling on hard times or another reaching an age where a distribution becomes appropriate. This flexibility comes with a distinct and generally less favourable tax regime compared with trusts giving beneficiaries a fixed, defined interest. For Income Tax, trust income not distributed to beneficiaries is taxed on the trustees at the trust rate (45% on non-dividend income, 39.35% on dividend income for 2026/27), though a lower rate applies to the first small band of trust income (currently up to 500 pounds) under standard rate band rules, and income actually paid out to a beneficiary can generally be reclaimed by that beneficiary against their own personal tax position via a form R185, since the trust income is treated as their income once distributed, grossed up for the tax already paid by the trust. Trust capital gains above the trust's own, much smaller Capital Gains Tax annual exemption (generally half the individual annual exempt amount, so 1,500 pounds for 2026/27 where there is a single trust, split between multiple trusts created by the same settlor) are taxed at the trust rates, 18% or 24% depending on the asset. For Inheritance Tax, most discretionary trusts created during the settlor's lifetime are subject to the "relevant property regime": an immediate lifetime IHT charge of up to 20% applies if the amount settled, plus any other chargeable transfers in the previous seven years, exceeds the settlor's available nil-rate band, then the trust itself is subject to a periodic charge of up to 6% of its value every ten years, and an exit charge (broadly proportionate to the periodic charge, based on how long since the last ten-year anniversary) whenever capital leaves the trust to a beneficiary. Because discretionary trusts face this combination of higher income tax rates, a smaller CGT exemption, and periodic and exit IHT charges, they are generally used deliberately for their flexibility and asset protection benefits (such as protecting assets from a beneficiary's divorce, creditors, or poor financial decision-making) rather than purely to minimise tax, and require ongoing professional administration to track the ten-year charge cycle correctly.

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