Discretionary Trusts and Inheritance Tax: How They Work and When to Use One
Discretionary trusts are one of the most flexible tools in inheritance tax (IHT) planning, letting trustees decide who benefits, when, and by how much, rather than fixing shares in advance. That flexibility comes at a cost, though: discretionary trusts sit inside their own IHT regime, with charges on the way in, every ten years, and on the way out. Here's how the rules work and when a discretionary trust is worth considering.
What is a discretionary trust?
A discretionary trust holds assets on behalf of a class of potential beneficiaries – typically children, grandchildren, or family members more broadly – without giving any one of them an automatic right to the trust fund. Instead, the trustees decide who receives what, and when, usually guided by a letter of wishes left by whoever set the trust up. That makes it a useful structure where future needs aren't yet known: grandchildren not yet born, a beneficiary who may need extra support later, or a family business that trustees may need to manage across generations.
Beneficiaries don't have to be minors or unborn. A discretionary trust can just as easily hold assets for adult beneficiaries of any age – you'd usually name a class, such as "my children and their descendants", and leave it to the trustees to decide who gets what and when. Because no beneficiary has a fixed right to anything until the trustees make an appointment, the assets get some protection if a beneficiary later divorces, runs into debt, or simply isn't ready to manage a lump sum – while the trustees keep control throughout.
How HMRC taxes a discretionary trust
Entry charge. A transfer into a discretionary trust is generally an immediately chargeable lifetime transfer (CLT), not a potentially exempt transfer. Lifetime IHT is charged at 20% on the amount above the settlor's available nil rate band – £325,000 for 2026/27 – though chargeable transfers made in the previous seven years can reduce the band actually available. If the settlor dies within seven years of the gift, additional IHT can become payable, recalculated at up to 40% with credit given for the 20% already paid, and taper relief reducing the extra tax due once more than three years have passed.
Ten-year (periodic) charge. On each ten-year anniversary of the trust, trustees pay IHT on the value of trust assets above the nil rate band available at that date. The rate is capped at 6% of the excess, and in practice is often lower once the calculation – which takes into account the settlor's earlier CLTs and any distributions already made – is worked through.
Exit charge. When capital leaves the trust between anniversaries, a proportionate exit charge applies, based on the rate set at the last ten-year charge (or at the trust's creation, before the first one) and the number of complete quarters the assets have been held. Distributions made within the first three months of setting up the trust escape the charge altogether.
Residence nil rate band. The extra £175,000 residence nil rate band (2026/27) is available where a home is "closely inherited" by direct descendants. It isn't automatically available just because a property sits in a discretionary trust – whether it applies depends on the trust structure and how and when the property passes to descendants, so this needs checking on the specific facts rather than assumed either way.
Income tax and capital gains tax
The IHT charges above aren't the only tax a discretionary trust picks up. Trust income above a £500 standard rate band is generally taxed at the trust rate of 45%, or 39.35% on dividend-type income. When income is later paid out to an adult beneficiary, it's treated as having already suffered tax at 45%. A non-taxpayer, basic-rate or higher-rate beneficiary may be able to reclaim some of this, generally through their own Self Assessment return or an R40 claim if they don't otherwise file – but an additional-rate taxpayer generally cannot reclaim anything, since 45% is already their own top rate.
Trustees generally pay CGT at 24% on taxable gains, using the trust's own annual exempt amount – £1,500 for 2026/27, subject to available reliefs. There's a useful offset on the way in, though: because putting chargeable assets into a discretionary trust is a chargeable lifetime transfer for IHT rather than a potentially exempt transfer, a settlor may be able to claim hold-over relief under s260 TCGA 1992 when gifting qualifying assets such as shares or property into the trust – deferring the capital gain until the trust, or its ultimate beneficiaries, eventually disposes of the asset.
Why families choose a discretionary trust
To potentially protect a vulnerable beneficiary, or help preserve entitlement to means-tested benefits – the effect depends on the particular trust and the beneficiary's circumstances.
To help keep wealth outside a beneficiary's estate, and potentially at arm's length from a divorce or creditors, depending on the trust terms and circumstances.
To retain control over how and when younger or as-yet-unborn beneficiaries benefit, rather than handing over a lump sum at a fixed age.
To manage succession of a family business or company shares without handing over control outright.
Points to weigh up
Discretionary trusts bring real ongoing compliance: registering the trust, valuing the fund at each ten-year point, usually annual trust tax returns, and now income tax and CGT to think about alongside the IHT position. The charges above are modest set against the 40% death rate they're designed to head off, but they're a genuine running cost, not a one-off. And someone has to be trusted to exercise the trustees' discretion well, long after the person who set the trust up is no longer around to guide them. Because unwinding a discretionary trust once assets are in it is rarely straightforward, it's worth taking advice before transferring anything – ideally alongside your solicitor, who will draft the trust deed itself.
If you're weighing up whether a discretionary trust fits your family's inheritance tax planning, get in touch with the Flow team – we can talk through the tax position alongside your solicitor.
Comments