What is a Discretionary Trust?

What is a Discretionary Trust? 

Before we consider the particular characteristics of a discretionary trust, let's first consider the business structure known as a trust.

A trust is a simply the separation of the legal ownership of an asset and the beneficial ownership or use of that asset. If an asset is held “on trust”, the person who is the owner of the asset is different from the person who gets the benefit or use of the asset.

A simple example of a trust arises where a parent gives their child a car, but rather than transfer the registration of the car to the child, leaves the registration in the parent's name. In this case the child would have the benefit and use of the car, but the registered (legal) owner would still be the parent – creating a simple trust.

There are many different types of trusts and of these, 2 principal types of trust are generally used in a business or investment context:

• Discretionary Trusts; and
• Unit Trusts.

Discretionary Trusts

Characteristics

The principal characteristics of a discretionary trust are that

1. the capital (including all monies and assets) and income are held by the trustee (the legal owner) on trust for a range of beneficiaries. The range of beneficiaries is often defined in terms of

1. 1. one or two people who are the principal beneficiaries,
   2. the relatives of the principal beneficiaries,
   3. companies owned by the principal beneficiaries and their relatives; and
   4. the trustees of other trusts of which the principal beneficiaries and their relatives are beneficiaries.
2. the distribution of capital and income to the beneficiaries is at the discretion of the trustee.
   
   

Distribution Discretionary

In any year the trustee can determine in respect of any of the capital or income held in the trust:

• to pay the capital (or some of the capital) to one or more of the beneficiaries and not to others,
• to pay income (or some of the income), to one or more of the beneficiaries and not to others,
• to retain capital or income in the trust (although there may be significant tax consequences associated with retaining income),
• to change the way income and capital is distributed in their discretion.
  

This obviously means that the trustee can favour one or more beneficiaries to the exclusion of the remaining beneficiaries.

It is not surprising then that a discretionary trust is normally used within a family group and not between business partners.

Appointor

The most important role in a discretionary trust is that of the appointor. This is the person (or persons) who can remove trustees and appoint new or additional trustees.

While a trustee can make a determination in respect of assets or income, if the appointor does not agree then the appointor can remove the trustee and appoint a new trustee. The appointment of a new trustee can also be used in a range of other circumstances and is entirely at the discretion of the appointor.

Advatages of a Discretionary Trust

The principal advantage of a discretionary trust is that allows flexibility in the distribution of income and capital. The corresponding disadvantage of a discretionary trust is that there is no guarantee of income or capital for any of the beneficiaries.

Unit Trusts

Characteristics

The principal characteristics of a unit trust are that

• the capital (including all monies and assets) and income are held by the trustee (the legal owner) on trust for specific beneficiaries. These beneficiaries are all specifically named and can be persons, companies or trustees of other trusts,
• the interest in the trust is divided into units and each of the beneficiaries is allocated a specific number of units (in consideration of a pre-agreed payment per unit),
• the interest that the beneficiary has in a unit trust is determined by how many units they have and how many units have been issued in total.
• the trustee MUST distribute income or capital to the beneficiaries in the proportion in which they hold units in the trust.
  
  

Distribution Fixed

Unlike a discretionary trust, trust distributions in a unit trust are fixed. For example if a beneficiary holds 30 per cent of the units in a trust then the trustee must pay 30 per cent of the income distributed to that beneficiary.

Discretionary Trust or Unit Trust?

There are a number of considerations in relation to whether you should use a trust and if so, whether you should use a discretionary trust or a unit trust, including taxation considerations. Before you decide whether and which type of trust you should use, you should speak to your adviser. Your adviser will consider your circumstances and provide advice about whether a trust is right for you (and if so what type of trust should you use).

Disclaimer

The information in this article is general in nature and is not intended to address the circumstances of any person or other entity. Although we do our best to provide timely and accurate information, we do not guarantee that the information in this article is accurate or that it will continue to be accurate in the future.