A discretionary trust is a trust in which the trustees decide who benefits, when and by how much. No beneficiary has a fixed right to the income or capital. The trust deed or will names a class of possible beneficiaries, such as "my children and grandchildren", and the trustees choose between them. That flexibility is why families use discretionary trusts. It comes with its own tax regime. A lifetime transfer in above the £325,000 nil-rate band is taxed at 20%. The trust can face charges of up to 6% every 10 years and when assets leave. Income is taxed at 45% (39.35% on dividends), and gains at 24%.
How a discretionary trust works
There are three parties. The settlor puts assets into the trust, during their lifetime or by will. The trustees become the legal owners and manage the assets. The beneficiaries are the people who may benefit. Depending on the deed, the trustees can decide:
- What is paid out. Income, capital or both;
- To whom. Any one or more of the beneficiaries, in any shares;
- When. How often payments are made, if at all;
- On what terms. Any conditions attached to a payment.
Because no beneficiary has a right to a defined share, assets held in a discretionary trust are not normally treated as part of any beneficiary's estate. That is the key difference from a bare trust, where the beneficiary is entitled to everything, and from an interest in possession trust, where a beneficiary is entitled to the income as it arises.
gov.uk lists two typical uses: providing for a future need that cannot be predicted now, such as a grandchild who may need more help than the others, and holding assets for beneficiaries who are not able or responsible enough to manage money themselves. A discretionary trust can also be created by will (a "will trust"), in which case the personal representatives must make sure it is set up properly and that the tax on the assets going in is paid. If the settlor or their spouse or civil partner can benefit, the trust is "settlor-interested" and special tax rules apply, generally taxing the settlor on the income.
Inheritance tax on a discretionary trust
Discretionary trusts fall within the "relevant property" regime of the Inheritance Tax Act 1984, which can charge tax at three points.
- Going in. A lifetime gift to a discretionary trust is not a potentially exempt transfer. It is a chargeable transfer straight away. Transfers into trust, together with other chargeable transfers in the previous 7 years, are tax-free up to the £325,000 nil-rate band. Above that, tax is charged at 20%, half the death rate, if the trustees pay it. If the settlor pays, the tax is itself treated as part of the gift, so the bill is higher. If the settlor dies within 7 years, the tax is recalculated at 40%, with credit for the 20% already paid;
- Every 10 years. On each 10-year anniversary, relevant property above the threshold is charged. The rate is three-tenths of the lifetime rate on a notional transfer under section 66, so it can never exceed 6% of the value;
- Coming out. When capital leaves the trust, an exit charge applies, also at a maximum of 6%. There is no exit charge on distributions within 3 months after the trust is set up or after a 10-year anniversary.
In practice, a couple can each settle up to their nil-rate band every 7 years with no entry charge, and a trust that stays within the threshold often pays little or nothing at the 10-year point. The calculations are detailed, though. They take in the settlor's other chargeable transfers in the 7 years before the trust was created, and other trusts set up on the same day. Charges are reported on form IHT100. One further cost: a home placed in a discretionary trust generally does not qualify for the residence nil-rate band, even if it later passes to the deceased's children.
Income tax and the 45% tax credit
The trustees pay income tax at the special trust rates in section 9 of the Income Tax Act 2007. For 2026/27, the trust rate is 45% and the dividend trust rate is 39.35%. Trustees do not get the dividend allowance. Most trusts are not taxed on income up to a tax-free amount of £500, but if income exceeds that, the whole amount is taxable. The £500 is shared between all the discretionary and accumulation trusts the same settlor has created, with a floor of £100 each where there are five or more.
Looking ahead, Finance Act 2026 adds a property trust rate and a savings trust rate of 47% each, which apply from the 2027/28 tax year. HMRC's trusts guidance does not yet reflect this. For 2026/27, rental and savings income remains taxed at 45%.
When the trustees pay income out, the beneficiary receives it with a 45% tax credit. A beneficiary who pays tax at 20% or 40%, or who is a non-taxpayer, can reclaim the difference on a tax return or on form R40. The trustees must keep a "tax pool" showing they have paid enough tax to cover those credits. If the pool falls short, they must pay the shortfall. Distributing income from a trust that receives mainly dividends is the classic trap.
Capital gains tax
Trustees pay capital gains tax at 24% on gains above the trust annual exempt amount, which is £1,500 for 2026/27 (£3,000 where a beneficiary is vulnerable). The allowance can be smaller where the settlor has created several trusts. Gains on UK residential property must be reported and paid within 60 days of completion. On transfers of assets into or out of the trust, hold-over relief may be available to defer the gain until the asset is later sold.
Running the trust
Trustees must register the trust on HMRC's Trust Registration Service. Most trusts must register even if they have no tax to pay. See registering a trust for the Trust Registration Service rules. They must also file a Trust and Estate Tax Return (SA900) each year: by 31 October on paper or 31 January online. And they must give beneficiaries a statement of income and tax (form R185) if asked. For how a discretionary trust compares with bare, interest in possession and other trusts, see our overview of estate planning trusts. For simpler alternatives, see gifting money to children.
HMRC's guidance is in trusts and inheritance tax and trusts and taxes. Acumon prepares trust tax returns, tax pool reconciliations and 10-year anniversary calculations through trust tax, and advises settlors before assets go in through inheritance tax planning. If a trust is approaching its 10-year anniversary, start gathering the historic transfer values well in advance.