Discretionary Trusts in the Context of Family Business Succession Planning

Ensuring the future of a family business is often of utmost concern to families and is a crucial decision that requires careful thought and planning.

A discretionary trust can provide a useful structure in order to pass on shares in a family business and offers protection for the benefit of future generations.  This article discusses important considerations for succession planning and the use of discretionary trusts in a family business context. 

What is a Discretionary Trust?

A trust is a separate entity.  When assets are placed into a trust the legal owners, known as the trustees, are usually (but not always and do not have to be) different to the individuals who are the beneficiaries of the trust.  This allows for certain individuals to retain control at the same time as passing on wealth and income to other family members.  For example, if shares in a family business were gifted into trust, the trustees (who could include the donor making the gift into trust) would have control over the shares and would exercise the voting rights associated with the shares.  At the same time, younger family members (as the beneficiaries of the trust) could benefit from any future dividends received and any future capital growth in the value of the shares.  Under a discretionary trust, there can be any number of beneficiaries and the trustees have the power to determine which beneficiaries should benefit, as well as when and how they might benefit.  The advantages of such a discretionary structure include asset protection, flexibility, and opportunities for tax and estate planning (both for the donor making the gift as well as for the beneficiaries of the trust themselves).

Asset Protection

A discretionary trust structure offers a degree of protection against the potential consequences that could arise if a beneficiary dies, divorces or suffers financial difficulties and is made bankrupt.  This is one of the advantages of using a discretionary trust compared to the donor making an outright gift to family members.  Assets held in a discretionary trust do not form part of the beneficiaries’ own personal estates and so cannot be gifted on by a beneficiary or left under a beneficiary’s Will.  For a family business where the entire shareholding or a majority shareholding is often owned by a family member, a discretionary trust provides a valuable mechanism to ensure that shares do not end up in the hands of non-family members, and that there is no dilution of a majority shareholding.  A trust can also ensure that the ownership of the shares continues to be consistent with the Articles of Association and provisions of any Shareholders’ Agreement.

Flexibility

The terms of the discretionary trust can be drafted to provide wide flexibility to share the wealth from a family business amongst younger and future generations.  The trust operates by providing the trustees with a general discretion to decide which of the potential beneficiaries should benefit, when and how. None of the beneficiaries will have a right to either capital or income. Trustees can, therefore, consider individual beneficiary’s circumstances, relationships, involvement in the family business, and general tax and other relevant considerations at the time. The trustees will be guided by any Letter of Wishes written by the settlor as the person who created the trust.  That letter will not be legally binding, but is often seen as ‘morally binding’, and is key where the trustees have so much flexibility. Further future proofing can also be secured by providing the trustees with the power to add (and remove) beneficiaries. Ultimately, therefore, a discretionary trust allows for a succession plan to be put in place whilst postponing the final decision about control of the family business and ultimate ownership of the shares to a later date.

Tax Considerations

The inheritance tax (“IHT”) and capital gains tax (“CGT”) consequences of any potential gift should be a central consideration before a gift is made into trust. There are several potential tax advantages to gifting shares or assets in a family business into a trust and it may be possible for the gift to be made without any immediate tax consequences. 

One important consideration is whether business property relief (“BPR”) is available in relation to the shares in the family business.  If BPR is available, qualifying business assets can benefit from 100% relief so that no IHT is payable on the transfer into trust.  This can be an extremely valuable relief.  BPR is only available for assets (including shares) held in a private trading company (a company that is ‘wholly or mainly’ trading, as opposed to an investment company) once the assets or shares have been owned for 2 years.  On the death of the donor who gifted the business assets, BPR may continue to be available (so that no IHT becomes payable on the business assets on the donor’s death) if the business assets are still owned by the trust and still qualify for BPR at that time.  In this way, the current favourable tax relief for qualifying business assets can be ‘banked’ now.  This may be of increased importance going forward if changes are introduced to the rules regarding BPR in the future.

The availability of BPR is also useful in the context of the IHT regime to which discretionary trusts are subject, where broadly speaking the value will be taxed at a maximum of 6% every 10 years.  If BPR is available on the shares, that charge could be nil.

A gift into trust is a disposal for CGT purposes, however, the gift can be made without any immediate CGT being payable if ‘holdover relief’ is available.  Ordinarily, if assets gifted have increased in value in the hands of the donor (between the date the donor acquired the asset and the date of the gift), there will be CGT to pay on the increase in value when the gift is made (subject to allowable expenses and CGT allowances).

If, however, holdover relief is available and claimed, then any CGT payable is essentially deferred until a later date.  This means that the trust would receive the asset with the donor’s base/acquisition value and the gains are ‘held over’ until the trustees make an actual disposal of the asset. Holdover relief may be available when the assets are put into trust and again when they are distributed out of the trust to a beneficiary.  In such circumstances, CGT would only be payable when the beneficiary in question later disposes of the asset in the future.  The arrangements can be structured to maximise any available individual or trust CGT allowances.

The tax consequences of making any gift will always depend on the circumstances at the time.  It is important to take comprehensive advice at an early stage when considering succession planning and gifting shares in a family business.