What is a Discretionary Trust?
As the name suggests, a discretionary trust is one in which the assets as well as the income of the trust are divided among the beneficiaries upon the discretion of the trustee. Usually when a trust is established, the beneficiaries of the trust are named clearly. The trustee then handles the assets of the trust for such beneficiaries and all income arising from the trust has to be given to the beneficiaries as specified in the trust deed. However, when the trustee is given discretionary powers as to choosing the beneficiaries of the trust as well as how much money each beneficiary should receive; then this type of trust is known as a discretionary trust. In Australia, discretionary trusts are often referred to as family trusts as they are generally established to manage the assets of a large family.
Hence, a discretionary trust is one in which the beneficiaries of the trust do not have a fixed or specified entitlement to the capital, assets, or the income of the trust. This is left to the discretion of the person who has been appointed as the Trustee of the discretionary trust. The trustee may have discretionary powers in the following areas:
- Choosing the beneficiaries of the trust: Often the trust deed may only specify a class of beneficiaries of the discretionary trust. However, which person from this group of beneficiaries should receive any income from the trust is left to the trustee’s discretion.
- Choosing the amount of payments: The trustee is also typically given the discretionary power to choose how much money, if any, should be distributed among the beneficiaries.
As per the terms laid out in the trust deed, the trustee could have one or both of the above mentioned discretionary powers. However, some trust deeds may specify the beneficiaries of the trust clearly and only leave the payments to the trustee’s discretion; or the trust deed may specify the amount of income to be distributed, but leave the choice of beneficiaries to the trustee’s discretion. Thus, till such time that the trustee has exercised his discretionary powers under the trust deed; no person can claim to be a beneficiary of a discretionary trust.
Advantages of a Discretionary Trust
Discretionary trusts are typically established to manage the assets of a family so that the assets can be protected from individual family members and also to reduce the tax liabilities arising from the income of the trust. Here are some of the main advantages of a discretionary trust.
- Protecting the assets of a family: If the assets of a family are held by any individual person in the family, then those assets can legally be attached to pay off any debts or liabilities of that person. However, if a discretionary trust is created and the assets of a family are settled upon the trust, then no individual member is the owner of such assets. Thus, in the case of any liabilities or creditors of any one family member, the family assets cannot be touched to pay off such debts. Similarly, if a family member is going through a divorce and all their assets are held under a trust rather than individually; those assets will be protected and will not become part of the divorce proceedings.
- To maintain control over minor family members: If there are any young members who are beneficiaries of a family trust, then it is possible to exercise control over such members through the trust. The amount of money paid out to them can also be controlled by the trustee, which helps in protecting the assets of the family from unwise decisions taken by young members.
- To reduce tax liabilities: A discretionary trust is a great way to reduce the overall tax liabilities that may arise from the income of the trust. Since the trustee has the power to choose which beneficiary should be given any payments from the trust income, they can choose members whose total income is lower than the taxable threshold. Hence, if a particular beneficiary is not earning any income, the trustee can choose to distribute some portion of the trust’s income to that person. If the amount is lower than the taxable threshold, then no tax liability will arise. Even if the amount is higher than the taxable threshold, the tax may be calculated at a lower rate. Therefore, if there are several beneficiaries who are not using their tax-free thresholds, then the income of the trust can be distributed among such beneficiaries, thereby reducing the overall tax liability considerably.
Since the trustee can make the decisions with respect to the beneficiaries and the amount of income to be distributed to them every year, it is possible to keep changing the beneficiaries as well as the amount of money paid to them so as to create the most favourable tax advantages for the trust.
Since the trustee of a discretionary trust has the power to choose the beneficiaries and distribution of income, it is vital to appoint a trustee who is honest, responsible and trustworthy and who will work towards the benefit of all the intended beneficiaries. However, the main power of a discretionary trust lies with the appointer, who has the power to choose the trustee for the trust. In order to ensure that the assets of the trust are protected and managed properly, it is advisable to name at least two appointers for a discretionary trust.