Trusts for disabled people
Disabled people and carers
Because of the need to comply with a number of complex but strict conditions, competent professional advice is essential when setting up or administering a trust for someone with a disability. Such advice might be taken from a:
- tax adviser – you can find a tax adviser on the Chartered Institute of Taxation website.
- trust and estate practitioner – you can find a practitioner on the Society of Trust and Estate Practitioners website.
- solicitor – you can find a solicitor on the websites of the Law Society, the Law Society of Scotland or the Law Society of Northern Ireland.
- Such a person should also be able to advise upon the impacts of a trust on the disabled beneficiary's benefits entitlement. In general, this will depend on the type of trust (money in a discretionary trust is usually not counted) and the type of benefits (please note that not all disability benefits are mean-tested).
The information that follows is intended purely as a brief outline of the tax rules and not in any way as a specialist text or as a substitute for proper professional advice. It is also restricted to trusts and beneficiaries resident in the UK.
In late 2018, HM Treasury issued a consultation document entitled The taxation of trusts: a review. No changes have yet been announced.
What are trusts (in general)?
In simple terms, a trust is a legal ‘wrapper’ to hold assets. The person who puts money (or other property) into the trust is called the settlor or donor. The settlor puts property into the trust, the trustees manage it and the only people who can get something from the trust are the beneficiaries. The trust deed is a legal document that lays out who is to look after the trust assets and who can benefit from the trust.
Ann wants to set up a trust for her sister. Ann is the settlor. Ann can choose the people to be trustees. In the trust deed she needs to make sure she explains precisely how she wants the trust to work and who can benefit from it. For example, she could say that any income in the trust should always be paid to her sister, or she could say that the trustees can choose whether or not to pay income to her sister.
The trust deed is an important document as it can be very difficult (and expensive) to change it later. For this reason, we strongly recommend taking professional advice.
Trusts are often portrayed as a way to avoid tax, but trusts are most often used to protect money (assets) or to protect people (so other people cannot access someone else’s money).
Why might a trust be set up for a disabled person?
A trust might be set up for a variety of reasons including:
- the disabled person may not (or may not always) be able to manage their own finances;
- an individual may wish to set aside funds for the disabled person, but retain control (via the trust deed) of what happens to the fund in the event the disabled person marries or dies, for example;
- it might protect the disabled person’s entitlement to means-tested state benefits.
What types of trust might be set up?
As above, there are various reasons for setting up trusts and the type of trust chosen might depend on that reason, but it may also depend on the tax issues associated with the trust and the costs of administering the trust. It is very important to take professional advice at the outset. You can read basic information on different types of trusts and their tax consequences on GOV.UK.
The simplest type of trust is a bare trust, which effectively means someone holds an asset on behalf of another, effectively as a nominee. A bare trust could simply be a bank account for someone but in the name of someone else, for example a bank account in the name of Mrs Smith for John Smith. The named account holder (Mrs Smith) is the owner in law (that is, the person who can operate the account), but the beneficiary (John Smith) is the person who must benefit from the funds in the account.
There are other types of trusts including discretionary trusts and interest in possession trusts. With discretionary trusts, trustees choose whether and to whom (from a list of beneficiaries set out by the settlor) to pay out trust income (this means that the beneficiaries have a mere ‘hope’ of receiving funds from the trust rather than an absolute right to funds). In an interest in possession trust, trust income must be paid to the beneficiary.
What are the tax implications of a trust?
In a bare trust, the beneficiary (subject to attaining his majority, for example reaching the age of 18 in England and Wales) has an immediate and absolute right to both the trust funds and any income generated by the trust fund, so the beneficiary is liable for any tax as if he held the property himself.
For most other types of trust, the trustees, as legal owners of property, are liable – like any other property owners – to pay income tax on the income arising from the trust property, and capital gains tax on any gain deriving from any sale or other disposal of the property.
However, if the settlor can benefit from the trust, normally any income and gains will be taxed on the settlor.
Historically, governments and HMRC have seen trusts as a way of avoiding tax and have consequently imposed higher rates of tax on trustees than on individuals. For example:
- Trustees have no personal allowances, and pay income tax on income accruing to the trust at 45%, and 38.1% on dividend income (apart from the first £1,000 of trust income or income in an interest in possession trust). If and when the income is distributed to individual beneficiaries, the trustees supply a form R185 showing how much tax has been deducted from the income, which the individual can then reclaim to the extent that they are chargeable at a lower rate(s).
- Trustees normally have half of the capital gains tax annual exemption available to individuals (£6,150 as opposed to £12,300, for 2020/21) and are chargeable to tax on gains above that amount at a rate of 20% (or 28% if residential property), in other words equal to the higher two rates payable by individuals. Beneficiaries themselves aren't taxed on any trust gains and cannot claim back (or take off their own tax bill) any capital gains tax paid by the trustees.
- Trustees are also, in the main, chargeable to inheritance tax to the extent that the value of the trust property exceeds the inheritance tax threshold (£325,000 for 2020/21). For most trusts, inheritance tax is chargeable at least once every ten years and also when property, other than income, leaves the trust. Further information about these charges can be found on GOV.UK.
Who might set up a trust for a disabled person?
There are other possibilities but these are the main categories of settlor that are commonly seen where the main beneficiary is a disabled person:
- A parent or other relative who sets up a trust for a child or other relative.
- An individual may set up a trust for themselves if they think they may need that protection in the future.
- An individual may set up a trust to received compensation monies (for personal injury, for example).
What is a disabled person’s trust?
In the context we are going to discuss here, a disabled person’s trust is one that is set up to conform with the requirements of section 89 Inheritance Act 1984. Broadly, such a trust avoids some of the harsher tax consequences of a trust.
What is a disabled person for these purposes?
For the trust to qualify as a disabled person’s trust, the person must be disabled at the time property is transferred to the trust (subject to a small exception where the person make a trust for themselves because they are likely to become disabled in the future).
In simple terms a disabled person is defined as:
- A person incapable of managing their property due to a mental disorder;
- A person in receipt of an attendance allowance;
- A person in receipt of a disability living allowance by virtue of entitlement to the care component at the highest or middle rate or the mobility component at the higher rate;
- A person in receipt of a in receipt of personal independence payment (for transfers from 8 April 2013);
- A person in receipt of an increased disablement pension (for transfers from 8 April 2013)
- A person in receipt of a constant attendance allowance (for transfers from 8 April 2013)
- A person in receipt of an armed forces independence payment (for transfers from 8 April 2013)
If the only reason the person is not in receipt of those benefits is:
- they are not resident or present in Great Britain or Northern Ireland; or
- they are undergoing treatment for renal failure in a hospital or similar institution as an outpatient; or
- they are residing in a care home where the cost of their accommodation, board and personal care is borne out of public funds,
- then they still qualify as a disabled person for these purposes.
The qualifying conditions for the ‘mental disorder’ test to be satisfied are less stringent than might be thought. HMRC accept the following conditions will count as a ‘mental disorder’ and enable a person to qualify as disabled under this head, if as a result of having the condition they are incapable of managing their affairs:
- Alzheimer’s or other forms of dementia;
- Bipolar disorder, schizophrenia, depression or other mental illness.
- In addition, those with the following conditions may qualify as having a mental disorder if as a result of the condition they are incapable of managing their affairs:
- Autistic Spectrum Disorder (although normally described as a pervasive developmental disorder);
- Learning disability, such as those with down’s syndrome.
Brain injuries, as such, are not a mental disorder because they may only have physical consequences (for example, loss of movement, or muscle control). But psychological, cognitive or behavioural disorders associated with or caused by them can be mental disorders.
Similarly, Parkinson’s is a neurological condition rather than a mental disorder. But like brain injuries it can lead to psychological, cognitive or behavioural problems that are mental disorders (for example, dementia).
It is very important to check whether or not the disabled person qualifies under these provisions as it can make a significant difference to the tax charges of both the trust and the disabled person.
Although normally the person needs to qualify as disabled at the time property is transferred to the trust, if it was reasonable for them to assume that they would fall within the definition of disabled in the future, they can set up a disabled trust for themselves. This might be the case, for example, if the person had been diagnosed with a degenerative disease.
What are the special rules for taxing a disabled person’s trust?
Where a trust beneficiary is disabled or ‘vulnerable’, the trustees may sometimes get special tax treatment provided certain conditions are satisfied both about the nature of the trust and the circumstances of the beneficiary. There are different conditions depending on whether the tax in question is:
- income tax and/or capital gains tax; or
- inheritance tax.
The special tax treatment broadly aims to tax the income and gains of the trust in the same way as if the individual beneficiary’s own allowances, reliefs and rates applied to the trust income and gains; and to ensure that for inheritance tax the 10-yearly tax charges that affect most other trusts do not apply.
Crucially, even if both the beneficiary qualifies as being disabled and the trust qualifies as a disabled person’s trust, the income tax and capital gains tax reliefs are NOT automatic. The trustees need to take action, sometimes along with the beneficiary (or their parent or attorney). If the trust was settled by the beneficiary for themselves, no income or capital gains tax relief will be available.
Which trusts do the special income tax/capital gains tax rules apply to?
The scope of these special rules includes trusts not only for disabled beneficiaries but also for beneficiaries under the age of 18 at least one of whose parents has died. This is why sometimes you will hear these rules known as applying to ‘vulnerable beneficiaries’ as they apply to a broader range of people than just disabled people. Neither income tax nor capital gains tax relief will be available where a beneficiary set the trust up for themselves.
Here we will only think about the special rules as they apply to disabled beneficiaries, hence our use of the term ‘trusts for disabled people’ (or disabled trusts) rather than ‘trusts for vulnerable beneficiaries’ – their official name.
For more information on trusts for vulnerable beneficiaries, you could look at HMRC’s manual.
What are the conditions that must be met for the special income tax/capital gains tax rules to apply to disabled beneficiaries?
The trusts themselves must qualify for special treatment, as must the beneficiary. Above we have set out the conditions necessary for the beneficiary to qualify as disabled. Remember that these special rules do not apply where a beneficiary set up the trust for themselves.
Trusts qualifying for special treatment
Property held on trust for a disabled beneficiary qualifies for special treatment if, while the beneficiary is alive or until the trust ends, if earlier:
- only the disabled person may receive trust property; and
- either the disabled person is entitled to all the income from the trust, or alternatively no other beneficiary is entitled to have any trust income applied for their benefit.
There are two small exceptions to this rule. Capital may be advanced to non-disabled beneficiaries (note carefully that the payments can only be made to beneficiaries named in the trust deed):
a) provided the trustees have the powers, up to £3,000 (or 3% of the value of the trust capital, if lower) per tax year, or
b) if general law gives the trustees such powers.
How do the trustees claim the special income tax/capital gains tax treatment?
There are two steps to getting the special treatment:
- If both the type of trust and beneficiary qualify as described above, the trustees and the beneficiary can jointly make a ‘vulnerable person election’, as described below. This election must be made within 22 months of the end of the tax year when it is first to have effect. It is irrevocable, but has no effect unless a further election is made, as described below.
- Once the vulnerable person election has been made, as above, this allows the trustees alone to take a decision year by year as to whether to make an election for special tax treatment. This special treatment aims to ensure that the trustees are liable to income tax and capital gains tax on the trust income and gains at the same rates as the beneficiary would have been had they been the beneficiary’s income and gains – usually meaning they pay less tax. Normally the trustees would make this election in the trust’s tax return but it can be made at any time up to 5 years from 31 January following the end of the relevant tax year.
Competent professional advice is needed to carry out any of the calculations to determine the lowest overall tax charge. See the introduction to this page for information on where to find such help.
How do the trustees make a vulnerable person election?
In order for the special tax treatment to apply, the trustees and vulnerable beneficiary must jointly and irrevocably make a vulnerable person election on form VPE1.
It can be completed on screen online. However, it must then be printed and signed by both the trustees and the vulnerable person. You will need to fill in the form fully before you can print it. You can’t save a partly completed form so you will need to gather all relevant information together before you begin to fill it in.
It is possible the disabled person may not be able to sign the election or lack capacity to do so. In these circumstances the election should be signed by the person properly appointed under a power of attorney or, failing that, the person appointed by court to deputise for them.
As noted above, the election has to be made within 12 months of the normal filing date for the trust tax return for which it is to have effect – that is, 12 months after the 31 January following the end of the tax year in question (so 31 January 2022 for 2019/20).
Once made it is irrevocable, but comes to an end if the beneficiary ceases to be a vulnerable person, or the trusts cease to qualify or come to an end.
How can I ensure the disabled person’s trust gets special inheritance tax (IHT) treatment ?
The need for competent professional advice is even more crucial when the rules for disabled person’s trusts for inheritance tax are added into the mix, especially where it is intended to take advantage of both the income tax/capital gains tax and inheritance tax regimes.
If you are a person looking to set up a disabled trust for someone, please note the following: a transfer of value into a disabled trust during your lifetime will be a potentially exempt transfer, (meaning there is only an IHT charge if you do not live for 7 years after you have made the transfer). Where a disabled trust is set up by the terms of your will, IHT will have to be paid as appropriate, before the transfer into the trust – there are no special rules to reduce or remove the IHT charge on death.
Please be aware that leaving money directly to the beneficiary so they can set up a disabled trust themselves may cause problems with the benefit system’s ‘deprivation of capital’ rules (the rules that apply to stop claimants depriving themselves of capital for the purpose of retaining or obtaining entitlement to means-tested benefits). The DWP could argue that by setting up a trust the beneficiary has deprived themselves of that capital in order to secure more benefit, and treat the beneficiary as still being in possession of the money.
A disabled trust is not subject to the ten-yearly charge or the exit charge, as described on GOV.UK, but is taxed as though the disabled beneficiary were entitled to the property in the trust in his or her own right. This means there is a charge to inheritance tax only when the beneficiary dies (any assets held in the trust form part of his or her estate) or if the trust comes to an end during his/her lifetime.
What are the conditions for the special inheritance tax rules to apply?
The trusts themselves must qualify for special treatment, as must the beneficiary.
Conditions to be fulfilled by the trust
In order to qualify as a disabled trust, the terms of the trust must provide that:
- during the lifetime of the disabled person, there must be no interest in possession in the settled property (in other words it must be a discretionary trust); and
- for property settled (put into the trust) before 17 July 2013, if any trust property is applied for anyone’s benefit during the life of the disabled beneficiary at least half must be applied for the benefit of that beneficiary; or
- where property is settled on or after 17 July 2013, any property that is applied during the lifetime of the disabled beneficiary must be applied for the benefit of that beneficiary (subject to the rule allowing 3% of the trust property, or £3,000 maximum, to be applied elsewhere in any tax year).
Conditions to be fulfilled by the beneficiary
To qualify, the beneficiary has to be a ‘disabled person’, for which the basic definition is the same as for vulnerable trusts above.
- Where property was transferred into a settlement before 6 April 2014, it was not possible for a person in receipt of only the mobility component of disability living allowance or personal independence payment to qualify as 'disabled' for inheritance tax.
‘Disabled person’ also includes, for inheritance tax purposes only, a person (the ‘settlor’) who transfers (or settles) their own property into a trust for himself or herself, at a time when they have a condition which it is reasonable to expect will lead to their becoming incapable by reason of mental disorder of administering their property or managing their affairs, or qualifying as a disabled person by virtue of satisfying the benefits test set out above.
For this to apply, the terms of the trust must provide that, during the lifetime of the settlor/beneficiary, no other beneficiary can benefit from the trust property.
There are also restrictions on what may happen if the trust is brought to an end during the lifetime of the settlor (for example, if the settlor’s condition improves). Either the settlor or another person must become fully entitled to the trust property in their own right, or the trust must continue as a disabled trust for the benefit of another beneficiary.
This extension to enable those who are about to lose capacity to create a disabled trust only applies where the person themselves settles the money. It is, therefore, of no use where the property to be put into trust belongs to someone other than the intended beneficiary – for example, if the parents of a child with a degenerative condition wish to place property into trust for the benefit of that child later in life.