Discretionary Trusts | Fortress Wills

Discretionary Trust

Discretionary trusts are widely used to protect family wealth, offering flexibility for trustees to respond to beneficiaries’ needs and shielding assets from divorce, insolvency, or poor financial decisions.

However, they do not automatically qualify for the Residence Nil Rate Band (RNRB), which can significantly increase inheritance tax if not planned for.

Residence Nil Rate Band

The RNRB (up to £175,000 per person, transferable between spouses) applies only when a qualifying residence is “closely inherited” by lineal descendants, either outright or through certain trusts such as an Immediate Post-Death Interest (IPDI). A purely discretionary trust fails this test on second death unless action is taken.

Here we outline three main ways to preserve the RNRB while still using a discretionary trust:

1. Appointment within two years (s144 IHTA 1984):

Trustees can appoint the residence (or a share) to lineal descendants within two years of death. This appointment is treated as if it were made by the deceased, allowing the RNRB to apply while retaining initial flexibility.

2. Outright gift of an RNRB-sized share:

A will can gift a share of the home equal to the available RNRB outright to descendants, with the remainder passing into a discretionary trust. This secures the RNRB automatically but sacrifices protection over the gifted portion.

3. IPDI for a lineal descendant:

Granting an IPDI over a share of the property equal to the RNRB qualifies as “closely inherited,” while the rest of the estate passes into a discretionary trust. This provides certainty but reduces flexibility and brings the IPDI share into the beneficiary’s estate for IHT.

Conclusion:

Discretionary trusts remain valuable for flexibility and asset protection, but they require careful planning to avoid losing the RNRB. With appropriate will drafting, trustee guidance, or timely post-death appointments, it is possible to balance tax efficiency with long-term family protection.

Disabled/Vulnerable Person Trust

Disabled/Vulnerable Person’s Discretionary Trusts are designed to support beneficiaries with disabilities while protecting their entitlement to means-tested benefits. Instead of inheriting directly under a will—which could trigger a local authority assessment and reduce benefits—assets are held in a discretionary trust with the disabled person as the principal beneficiary (alongside at least one other beneficiary, as required for a discretionary trust).

Key points include:

Benefits protection: Assets held in the trust are not treated as the disabled person’s own, helping preserve eligibility for disability benefits.

Inheritance tax on death: Any IHT due on the testator’s estate is paid before assets enter the trust (40% on value above the £325,000 nil rate band).

Favourable trust taxation: While the principal beneficiary is alive, the trust is exempt from 10-year anniversary charges and exit charges.

Limited benefits to others: Trustees may apply up to £3,000 or 3% of trust capital per year (whichever is lower) to other discretionary beneficiaries, with the remainder used for the principal beneficiary. This maintains the trust’s favourable tax treatment.

On death of the principal beneficiary: The Trust fund is subject to IHT at 40% on value above the nil rate band (NRB).

The Trust then continues as a standard Discretionary Trust, with anniversary and exit charges deferred for 5 years after the principal beneficiaries death.

Overall, these trusts balance financial support, tax efficiency, and protection of state benefits for vulnerable individuals.

Both PPTs and RTOs pass a deceased person’s property to trustees, who must allow specified individuals (Occupants) to live in the property for a defined period (e.g. for life, a fixed number of years, on remarriage, or reaching a certain age). During this time, trustees generally cannot sell the property without the Occupant’s written consent.

Key similarities:

Trustees must allow the Occupant(s) to live in the property, subject to conditions (maintenance, insurance, outgoings).

A trust period is defined.

Both can include powers allowing the Occupant to move to a new property using sale proceeds.

Both may include trustee discretion to revoke or reduce the Occupant’s entitlement.

Main practical difference:

PPT: The Occupant is entitled to any trust income and trustees may advance capital to the Occupant (outright or by loan).

RTO: The Occupant only has the right to live in the property—no automatic right to income or capital.

Inheritance Tax (IHT) treatment:

PPTs: If created by will and effective immediately on death, they are treated as an Immediate Post-Death Interest (IPDI) and a qualifying Interest in Possession (IIP). The Occupant is treated as inheriting the assets for IHT. Spouse/civil partner exemption usually applies. No periodic charges during the Occupant’s lifetime; on the Occupant’s death, the trust assets form part of their estate.

RTOs: Usually taxed the same as PPTs unless trustees have an overriding power to revoke the RTO. If so, HMRC may treat it as a relevant property trust, potentially triggering IHT on death and ongoing anniversary/exit charges (up to 6%).

Delayed trusts: If either trust does not take effect immediately on death (e.g. a trust following another trust), it will be treated as a relevant property trust rather than an IPDI, with corresponding IHT implications.

Bottom line:

PPTs provide broader financial rights (income and capital) and more predictable IHT treatment, while RTOs are narrower rights to occupy and can carry additional tax risk if revocation powers are included or the trust starts later.