Trust distributions in a (potentially) changing tax landscape

The question "should we distribute before the Budget?" is too narrow. The better question is whether the distribution serves the trust's purpose and improves the family's position after tax, investment and estate planning are considered.

Please note, this article is based on current legislation and announced policy at the time of writing. Tax treatment depends on individual circumstances and may change. It is not personal financial advice or a recommendation to take any particular action.

A discretionary trust has its own tax position. The trustees are generally responsible for dealing with tax on income and gains within the trust, while a beneficiary’s position is considered separately when they receive a distribution. The two are connected, but they are not the same.

Trust income is often taxed at a high rate, although a beneficiary may be taxed differently when they receive a payment. An income distribution will usually carry a tax credit, and the beneficiary may be able to reclaim some or all of that tax depending on their wider circumstances. The trust’s tax bill is therefore not necessarily the beneficiary’s final bill.

Other types of trust can work differently. A bare trust, or a trust in which a beneficiary has a right to income, may produce a different result. The trust deed, the source of the money and the beneficiary’s wider income all matter. Looking only at the amount available to distribute can therefore give an incomplete picture.

As the name suggests, an income distribution is a payment from trust income. A capital appointment is a decision by the trustees to pass trust capital to a beneficiary. The distinction matters because the tax and legal consequences can differ.

A payment from trust capital is normally capital in the beneficiary's hands rather than taxable income but calling a payment capital does not settle the tax treatment. The trust deed, the trustees' decisions, the accounts and the nature of the payment all need to be considered. Accumulated income can form part of trust capital, and a payment of an asset can create a gain for the trustees even if the beneficiary does not receive income.

There may also be an inheritance tax (IHT) consequence. Most property in a discretionary trust is relevant property, which can be subject to charges when assets leave the trust and at 10 year anniversaries. Some capital payments are exempt from an exit charge, while others are not. In some cases, capital gains tax (CGT) relief may be available when an asset is appointed, but that needs to be established rather than assumed.

Before a payment is made, trustees should identify whether it is income or capital, which asset or account it comes from, what documents are needed and what taxes may arise at each stage.

There is always speculation ahead of a Budget, and this year is no different, but so far there is very little relating specifically to ordinary discretionary trust distributions. There is commentary speculating there will be a wider focus on IHT and the treatment of trusts, following recent measures affecting certain trust charges and trust assets, but ahead of the Budget, it’s impossible to be sure about any potential changes to ordinary discretionary trust distributions.

For many discretionary trusts, an approaching ten year anniversary is an important planning date. A charge may arise on assets held in the trust at that point, while a payment made before the anniversary may also give rise to a separate charge, often called an exit charge. The outcome depends on the trust’s assets, when they entered the trust, earlier distributions and any reliefs available. It is not simply a question of how much is paid out.

The run up to an anniversary should therefore prompt an orderly review, not a last minute rush. Trustees may want to confirm the relevant date, obtain current valuations, check whether reliefs apply and ensure there is enough cash to meet a possible tax bill or planned distributions. Where the trust holds a business, land or other assets that may qualify for relief, the position should be checked before ownership is changed or assets are sold.

A payment made before the anniversary will not automatically improve the family’s position. It may create a charge, change who owns the asset and reduce the trust’s ability to respond to future needs. Planning early gives trustees time to understand the choices and record the decision. The Budget may change the wider rules, but it should not turn a considered trust decision into a reaction to speculation.

Distributing before a Budget may be sensible where a beneficiary has a genuine need, a planned gift is due to be made or the trustees have already decided that the trust should move from holding assets to supporting the family. It is less convincing when the only reason is a fear that the rules may become less generous.

A capital appointment can move an asset into a beneficiary’s ownership. The beneficiary would then receive any future income, growth or losses from it, and the asset would form part of their estate. This may also change how the investment fits with their wider financial circumstances. It can reduce the trust’s ability to meet expenses, tax or future requests for support. The family may gain cash or control today but lose flexibility tomorrow.

Rules announced in the Budget may have specific effective dates and transitional provisions. A payment made in haste may not achieve the treatment suggested by a rumour. It may instead create an irrevocable change in ownership before the family has agreed what it wants to achieve.

Before timing a distribution it’s important to consider:

• Would the trustees make this payment if the Budget made no change?

• Is the payment needed for the beneficiary, or is it being made only to secure a possible tax advantage?

• What is the outcome under current rules and reasonable alternative scenarios, including income tax, CGT and IHT?

• What will the trust and the beneficiary need the remaining assets to do?

Discretionary beneficiaries usually have no fixed entitlement until the trustees exercise their discretion. The trust deed sets the legal framework. A letter of wishes may explain the settlor's intentions, but it does not replace the deed or turn a request into an instruction.

Trustees should be able to show what they considered, why the decision was within their power and how they treated the interests of the beneficiaries. That requires more than a bank transfer. Minutes, valuations, deeds of appointment, tax calculations and records of the source of the payment should be kept. Records of income payments are also needed for tax reporting.

Fairness does not always mean equal amounts. One beneficiary may need help with housing or care, while another may have a larger income and a greater interest in preserving capital for the next generation. A fair decision can therefore produce different outcomes, provided the trustees have considered the trust's purpose and applied a consistent approach.

The approach has a family benefit as well as a legal one. Clear records make it easier to explain why a decision was made and reduce the risk that a tax driven payment is later seen as arbitrary or unfair.

A discretionary trust can control the pace at which capital reaches a young or vulnerable beneficiary, keep a family business under a coherent ownership structure, or allow trustees to respond to changing needs over time.

Those benefits are not automatic. A distribution can weaken the trust's protective or succession purpose by putting assets beyond the trustees' control. Nor is a trust an absolute shield against every future event. Divorce, bankruptcy, residence and other legal circumstances can affect how protection works.

The right question is therefore not simply whether a distribution saves tax. It is whether it leaves the family with the right balance of access, protection and control.

Trust investments should not be managed in isolation from the trust's wider objectives. An effective investment strategy begins with a clear understanding of why the trust exists, who it is intended to benefit and over what timeframe those benefits may be delivered. A trust established to preserve wealth for future generations may require a very different investment approach from one that is expected to support beneficiaries with regular distributions over the next few years.

The trustees should ensure that the investment strategy reflects the trust's objectives, anticipated distribution requirements, tax position, liquidity needs and investment time horizon. The portfolio should be capable of supporting both current and future beneficiaries, balancing the need for growth, income and capital preservation as appropriate to the trust's circumstances. Decisions about distributions should therefore be considered alongside the investment strategy, as a significant capital payment may alter the trust's ability to meet its long-term objectives.

An understanding of risk is central to this process. Trustees need to consider both the trust's capacity for loss and its tolerance for investment volatility in the context of its obligations to beneficiaries. The value of investments can go down as well as up, and the trust may get back less than originally invested. Trustees therefore should understand how different investments behave, the potential impact of market fluctuations and whether the trust could continue to meet its objectives during periods of adverse market conditions.

Trustees also have ongoing fiduciary responsibilities in relation to trust investments. These responsibilities do not end once a portfolio has been established. Investment arrangements should be reviewed regularly to ensure they remain appropriate as markets change, beneficiaries' circumstances evolve and distribution plans develop. Where investment management is delegated to professional advisers, trustees retain ultimate responsibility for oversight and should satisfy themselves that the portfolio continues to align with the trust's objectives and the interests of its beneficiaries.

Professional investment management can help trustees develop and maintain an investment strategy that is consistent with the trust's purpose, while financial planning can place potential distributions in the wider context of beneficiaries' cashflow needs, pensions, estate planning and long-term financial goals. Bringing these disciplines together can help trustees make considered decisions that reflect both immediate needs and the trust's longer-term responsibilities.

The Budget may change the rules. It need not change the discipline: understand the trust, model the alternatives, record the decision and make the distribution at the right point

At Evelyn Partners, we bring financial planning and investment management into the same conversation. That joined up view helps trustees and families assess the tax position without losing sight of purpose, fairness or control. It helps them move forward with clarity and confidence.

For more information, speak to your usual Evelyn Partners contact or book an appointment online.