Common errors when drafting discretionary trusts

The SWW Technical Team have put together an article which takes a look at some of the most common errors made when drafting discretionary trusts.

1. Only naming a single beneficiary.

A key element of a discretionary trust is that there must be multiple potential beneficiaries who can benefit from it. The trustees’ discretion is over not just how to manage the capital and income of the trust fund, and when to make distributions, but who those distributions should be made to.

If there is a single beneficiary and no potential for new beneficiaries to be added to the trust then what you have is not truly a discretionary trust at all. For tax purposes it would be treated as either a bare trust or an interest in possession, depending on the default clause.

If there is only one possible potential beneficiary, no scope for future beneficiaries to be added to the class, and that sole beneficiary also has a vested absolute interest because they are also the default beneficiary then the trust would be treated as a bare trust.

If there is a sole beneficiary, no scope for future beneficiaries to be added to the class, but the default beneficiary is different then the beneficiary may be treated as though they have an interest in possession.

Both of these situations should be avoided, considering one of the main strengths of a discretionary trust is that the assets are kept outside of the potential beneficiaries’ estates for IHT purposes.

To avoid this a discretionary trust is best defining the beneficiaries by reference to a wide class. Alternatively, a power for the trustees to add further beneficiaries to the class. This way even if the pool of beneficiaries is reduced to one the class remains open and the trust continues to be discretionary.

2. Having a very limited pool of beneficiaries

Only naming a couple of individuals can work fine initially. It may never cause a problem at all if the intention is for the trust to be wound up fairly quickly after the testator’s death. Problems arise where the trust carries on for a prolonged period and inevitably the beneficiaries die, eventually leaving a sole beneficiary. The trust is then faced with the same issues as described in point 1.

3. Misunderstanding the point of a default clause

A discretionary trust can last for up to 125 years. This is the maximum perpetuity period allowed by law according to the Perpetuities and Accumulations Act 2009. The reason English trusts have a maximum perpetuity period at all is because there is a general legal principal that a person cannot tie up their assets in trust indefinitely. At some point the assets have to actually vest in someone. This is known as the ‘rule against perpetuities’, and sometimes ‘the rule against remoteness of vesting’.

What this means for discretionary trusts is that there needs to be a default beneficiary, and this needs to be a person who can take any assets in the trust fund at the point the trust ends. The circumstances in which a discretionary trust will end with assets still in it would be:

a) All of the potential beneficiaries have died.
b) The trust has reached the end of its 125-year perpetuity period.

Without a valid default clause any remaining funds result back to the testator’s estate, so in a worst scenario where the discretionary trust was a trust of residue the resulting fund would pass on intestacy.

Naming the potential beneficiaries of the trust as the default beneficiaries can be done, but drafters need to understand what is actually being achieved by this. In the case of naming individuals it seems that this is often done in the mistaken belief that those beneficiaries would be living and able to take if the trust failed, but this is not the case since the trust would be failing after those people have died. The actual effect would be that a share of the trust fund would pass to these defaults’ estates and subsequently pass according to their own wills, as long as the clause didn’t include the condition that they be living at the end of the trust – This is usually not what the testator had in mind and they would have preferred to have had some control over where the assets would pass if the beneficiaries died.

A default clause like “to such beneficiaries as are living upon the determination of the trust” is strong, provided it’s likely that the trust will end naturally with members of the class still living, for example if a wide class like “my descendants” was used. Obviously there is still potential for the default to fail as the trust may have actually ended because there were no descendants living, so a safe long stop clause is always a charity.