What is a discretionary trust?
A discretionary trust is a trust where trustees have a wide discretion to apply income and capital for the benefit of certain beneficiaries. The trustees decide when, how, and to whom the trust fund is allocated from the pool of beneficiaries, known as the principal objects, within the trust. A beneficiary of the trust does not have an automatic right to receive anything from the trust, if and until the trustees exercise a discretion in their favour. In addition, a discretionary trust can exist for tax purposes where trustees accumulate income and do not distribute that income. A discretionary trust can be created during a person’s lifetime or they can be created by Will taking effect after a person’s death.
Benefits of trust assets in a discretionary trust
Discretionary trusts are very useful vehicles which can assist greatly in succession planning. They offer a great deal of flexibility in providing for young children, beneficiaries with disabilities or vulnerable adult beneficiaries and as asset protection measures. They are particularly beneficial for individuals who are unable to manage their own financial affairs due to factors such as disability or addiction.
- Protects the social welfare entitlements of beneficiaries.
- Allows a great deal of flexibility- so that trust can respond to changing circumstances of beneficiaries.
- Prevents over reliance on state supports and intervention.
- Can be used for efficient tax planning- creating a time lag to afford beneficiaries time to qualify for certain valuable reliefs such as dwelling-house relief, agricultural relief and business relief.
- Assets can be protected from creditors as beneficiaries do not actually own the trust assets.
- Can ensure that beneficiaries are sufficiently mature to handle an inheritance of significance
- Can allow flexibility in the distribution of the assets on death to beneficiaries, particularly where it is difficult to anticipate their future needs and facilitates a wait and see approach.
- It can be mechanism to provide for adult beneficiaries who suffer from alcohol, drug or gambling addictions, without risk of the assets being depleted by reckless management.
Taxation of discretionary trusts
One key tax is discretionary trust tax. This tax was introduced in 1984 and consists of an initial levy and an annual levy. There is an exemption from this tax for trusts exclusively set up for incapacitated persons. Discretionary trust tax applies to the entire value of the trust subject to certain exceptions.
The initial levy is 6%. It will apply on the latest of the following dates:-
- The date the discretionary trust is set up.
- The date of death of the settlor.
- The date the youngest principal object reaches 21 – a principal object is a spouse, civil partner, children, or minor children of a predeceased child.
Therefore if the answer to any of the following questions is YES, then no charge to discretionary trust tax arises:-
- is the settlor still alive,
- is there a principal object under 21.
If the initial levy arises, it must be accounted to the Revenue Commissioners within 4 months.
In addition, the trustees can avoid discretionary trust tax, if they appoint out assets to a beneficiary for their life, or for a minimum duration of 5 years so that the beneficiary is entitled to the income from those assets.
If the trust is wound up within 5 years of the initial levy a refund of 3% is available, which must be claimed from the Revenue Commissioners- it will not issue automatically.
The annual levy is 1% and applies to the entire funds that are within the trust fund. It commences the year after the year the initial levy arose. The annual levy will continue to apply for as long as the discretionary trust remains in being and is assessed on the value of the trust on the 31st December each year. The tax return must be submitted within four months of the relevant valuation date to avoid a surcharge.
Therefore trustees will face a difficult choice between distributing the assets to the beneficiaries before they reach 21 to avoid tax or retaining the assets in the trust and suffering discretionary trust tax.
Capital Gains Tax and Discretionary Trusts
Capital Gains Tax (CGT) is a significant consideration for discretionary trusts in Ireland. When a discretionary trust disposes of an asset, CGT may be payable on the gain made. The trust is liable to CGT on its worldwide gains, unless the trust is exempt from tax. The CGT rate applicable to discretionary trusts is 33%, which is the standard rate of CGT in Ireland.
The CGT liability of a discretionary trust is calculated by reference to the market value of the assets at the date of disposal. The trust is entitled to claim a credit for any CGT paid by the settlor or a previous owner of the asset. Additionally, the trust may be eligible for relief from CGT on the disposal of certain assets, such as business assets or agricultural property.
Given the complexity of CGT liability for discretionary trusts, it is crucial to obtain comprehensive tax advice before setting up a discretionary trust. Proper planning and expert guidance can help navigate the tax implications and optimize the trust’s financial affairs.
Exemption from discretionary trust tax
The exemption applies where the trust is set up exclusively for an incapacitated beneficiary and no other persons. If the trust includes other beneficiaries who are not incapacitated, then the exemption will not apply. Children under the age of 18 are deemed to be incapacitated, but loose that designation once they reach 18. If there are other beneficiaries, it is recommended to set up separate trusts.
This exemption only applies to discretionary trust tax and not to other taxes such as Capital Gains Tax, Income Tax, and Capital Acquisitions Tax.
Administration and Compliance
The administration and compliance requirements for discretionary trusts in Ireland are governed by the Taxes Consolidation Act 1997 and the Capital Acquisitions Tax Consolidation Act 2003. The trustee is responsible for ensuring that the trust complies with all relevant tax laws and regulations.
Each year, the trustee must file an annual return with the Revenue Commissioners, detailing the trust’s income, gains, and losses. Any tax due on the trust’s income and gains must be paid within the specified timeframe. This ensures that the trust remains in good standing with the tax authorities.
Beyond tax compliance, the trustee must also administer the trust in accordance with the terms of the trust deed and Irish law. This includes managing the trust assets prudently and distributing them in line with the trust’s objectives. Proper administration is key to maintaining the trust’s integrity and achieving its intended purposes.
Letter of wishes
We would also recommend when setting up a discretionary trust to incorporate a letter of wishes. This is a very individual letter from the settlor to the trustees- essentially an operating guidance manual for the trust. It may include for example a direction on the manner of distribution of the trust fund and how the trust is managed. The letter of wishes is non- binding on the trustees, but nonetheless is a helpful guidance and instruction to the trustees of the expressed intentions and views of the settlor. Only the trustees will have sight of this document.
Beneficiaries and Asset Protection
One of the primary benefits of a discretionary trust is the ability to protect the trust assets for the benefit of the beneficiaries. The trustee has a fiduciary duty to act in the best interests of the beneficiaries and to ensure that the trust assets are managed and distributed in accordance with the trust’s objectives.
The beneficiaries of a discretionary trust can include individuals, companies, or other trusts. The trustee has the discretion to distribute the trust assets to the beneficiaries as they see fit, within the framework of the trust deed and Irish law. This flexibility allows the trustee to respond to the changing needs and circumstances of the beneficiaries.
In addition to protecting the trust assets, a discretionary trust can also provide asset protection for the beneficiaries. Since the trust assets are held in the name of the trustee rather than the beneficiaries, they are shielded from creditors and other third parties. This can be particularly beneficial in safeguarding the financial interests of vulnerable beneficiaries.
Tax Planning and Optimisation
Discretionary trusts can be powerful tools for tax planning, helping to minimise tax liabilities and optimize tax efficiency. By strategically managing the trust’s income and assets, it is possible to reduce income tax, capital gains tax, and inheritance tax liabilities.
For instance, a discretionary trust can reduce income tax liabilities by accumulating income and gains within the trust, rather than distributing them to the beneficiaries. This approach can be advantageous for beneficiaries who are not resident in Ireland or who are not subject to income tax.
Similarly, a discretionary trust can help mitigate capital gains tax liabilities by holding assets over a long period, thereby deferring the CGT liability. Additionally, the trust can be structured to take advantage of various reliefs and exemptions, such as those available for business assets or agricultural property.
Inheritance tax liabilities can also be reduced through careful planning. By holding assets within the trust for the benefit of future generations, it is possible to manage the timing and manner of distributions, thereby optimising the tax outcomes for the beneficiaries.
Capital Acquisition Tax
Capital Acquisition Tax (CAT) is a tax on gifts and inheritances in Ireland. A discretionary trust can be an effective vehicle for minimising CAT liabilities by allowing the trust to hold assets for the benefit of future generations.
By accumulating assets within the trust rather than distributing them immediately, the trust can reduce the CAT liabilities for the beneficiaries. This strategy can be particularly useful for beneficiaries who are not resident in Ireland or who are not subject to CAT.
In addition to reducing CAT liabilities, a discretionary trust offers flexibility and control over the distribution of assets. The trustee has the discretion to distribute the trust assets to the beneficiaries as they see fit, within the parameters set by the trust deed and Irish law. This flexibility allows the trustee to adapt to the beneficiaries’ changing needs and circumstances, ensuring that the trust’s objectives are met effectively.
No charge to “Capital Acquisitions Tax” (CAT) arises on the creation of a discretionary trust as the potential beneficiaries do not have any beneficial entitlement to any of the assets. A charge to CAT may arise when the beneficiary receives a benefit from the trust.
Each beneficiary has a CAT free threshold below which no tax will be charged. Where the current benefit and any previous gifts or inheritances arsing within the same group (since the 5th December 1991) exceed the threshold, CAT is levied on the excess.
However under Section 84 of the Capital Acquisitions Tax Consolidation Act 2003, a benefit taken exclusively for the purpose of discharging qualifying medical expenses of an individual with a disability is exempt from CAT. Qualifying medical expenses are defined as expenses relating to medical care, including the costs of maintenance in connection with medical care.
There are various reliefs from Capital Acquisitions Tax, the relevance of which will depend on individual circumstances.
Top Tips
- Ensure you choose your trustees wisely so that the care and responsibility of the beneficiary can continue after your death. Trustees in the main should have business acumen, be trusted and independent and seek advice when necessitated.
- Ensure your trustees have the sufficient resources and flexibility to react to the changes in circumstances of the trust beneficiary.
- Ensure through a discretionary trust that the beneficiary has choices rather than exclusively relying on state supports.
- Ensure a proper procedure is put in place for the financial care and indeed hands on care of any incapacitated beneficiary.
- Ensure trust is set up exclusively for an incapacitated beneficiary to qualify for exemption from discretionary trust tax.
- Determine what will happen any surplus funds from the trust on the death of the beneficiary.
