I have been involved in drafting a couple of these sorts of trust arrangements over the years. It is more in the nature of an escrow arrangement than a trust and anyone who just drafts a simple discretionary settlement with a few extra terms tagged on is probably not doing justice to their instructions. The trust must comply with the relevant provisions in The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (which I suspect were not drafted by someone with any real knowledge of trusts). The order stipulates inter alia that the provider must undertake to secure that sums paid by the customer under the contract will be held on trust for the purpose of providing the (contracted for) funeral. Of course, purpose trusts don’t exist in English law so you can’t take that part of the legislation too literally; but equally it doesn’t sound to me as though the trustees are supposed to have a lot of discretion about what they do with the money paid over to them.
The IHT consequences are worth pondering but for the reasons given above they don’t seem to cause anyone a loss of sleep. The position was different pre-2006 when, if the trust was viewed as an IIP trust, and if a close company (the funeral provider) were the beneficiary of the income, the payment of funds out of the trust could give rise to a chargeable transfer by the shareholders (under the IHT rules applicable to close companies).
The other very salient question to consider is the income tax consequence of this sort of arrangement. Working out who the income belongs to is not easy - it may depend on a future contingency. For example, usually, the settlor is entitled to have his money back with interest if he cancels his contract. So perhaps the income belongs to him? But it would be an administrative nightmare for the operator of the plan to send an R185 to every customer once per year (who could then claim the tax from the trust - after having obtained a certificate as to the amount from HMRC!). Obviously that result is best avoided, but doing so requires a fair degree of thought concerning the terms of the trust and the wider arrangement which it supports.
Interestingly, similar trusts can be created to hold deposits paid to travel operators so as to provide assurance that the deposit will be used for the purpose for which it was paid (i.e. as an alternative to ABTA bonding). As you might expect, the relevant rules in the Package Travel Regulations do not mirror the rules for funeral plan trusts so unfortunately you can’t simply top and tail one trust document so as to create the other.