Trusts for disabled people
Here we give you guidance on these special trusts and who can take advantage of them.
Because of the need to ensure compliance with a number of complex but strict conditions, it is essential to take competent professional advice when setting up or administering a trust for someone with a disability, e.g. 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 Law Society website.
Such a person should also be able to advise upon the impacts of a trust on any benefits the disabled beneficiary is in receipt of. 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 means 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. For a specialist text, we can suggest Trust Taxation and Estate Planning, 4th Edition, by Emma Chamberlain and Chris Whitehouse, published by Sweet & Maxwell.
What are trusts (in general)?
In simple terms, a trust is a legal ‘wrapper’ to hold assets. The donor (or settlor) creates a trust by giving property (the trust fund) to trustees who hold the property (and income from it) on behalf of one or more persons (beneficiaries).
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 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 will be paid to the beneficiary as of right. Find a brief outline of different types of trusts and how they are taxed on the GOV.UK website.
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 trusts, 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 (usually the difference between the sale proceeds and the original purchase price plus the costs of any improvements or enhancements of a capital nature).
Historically, governments and HMRC have seen trusts as primarily a tax avoidance vehicle and have consequently imposed higher rates of taxation of both income and capital gains 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 have half of the capital gains tax annual exemption available to individuals (£5,850 as opposed to £11,700, for 2018/19) and are chargeable to tax on gains above that amount at a rate of 20% (or 28% if residential property), i.e. equal to the higher two rates payable by individuals. Beneficiaries themselves aren't taxed on any trust gains and don't get credit for any tax paid by the trustees.
They 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 2018/19). For most trusts, inheritance tax is chargeable at least once every ten years (the 'periodic charge') and also when property, other than income, leaves the trust (the 'exit charge'). The rates are tailored in such a way that, very broadly, every thirty years or so trustees will have paid the same amount of inheritance tax as if the property had been charged to tax once at the rate applicable on death.
The rate of tax on the ten-yearly periodic charge is 30% of the lifetime rate of IHT which is 20% i.e. a maximum rate of 6%, and the exit charge that arises when property leaves the trust is a proportion of that amount depending on the amount of time that has elapsed since the setting up of the trust, or the last ten-year anniversary.
Are there any special rules for the taxation of trusts for disabled people?
Where a trust beneficiary is disabled or ‘vulnerable’, the trustees may sometimes get special tax treatment provided certain conditions are satisfied about the nature of the trust and the circumstances of the beneficiary. Unhelpfully, these conditions vary depending on whether the tax in question is income tax or capital gains tax on the one hand, or inheritance tax on the other.
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 (i.e as if it were a bare trust), and to ensure that for inheritance tax the 10-yearly tax charges that affect most other trusts do not apply. Essentially the aim is to reduce the tax payable by the trustees out of the trust so that funds are preserved in the trust for the benefit of the disabled person.
Who do the special income tax/capital gains tax rules apply to?
For income tax and capital gains tax, the special tax treatment was introduced in 2005. Its scope 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.
Here we will only think about the special rules as they apply to disabled beneficiaries, hence our use of the term ‘disabled trusts’ (or trusts for disabled people) 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.
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 earlier termination of the trust:
- any trust property that is applied for the benefit of any beneficiary is applied for the benefit of the disabled person; and
- the disabled person is entitled to all the income from the trust, or alternatively, if there is no 'interest in possession', no other beneficiary is entitled to have any trust income applied for their benefit.
That is not to say that other beneficiaries may not benefit from advancement of trust capital. Capital may be advanced to non-disabled beneficiaries:
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.
Beneficiary qualifying for special treatment
The beneficiary must be a disabled person. For this purpose a disabled person is one who:
- by reason of ‘mental disorder’ within the meaning of the Mental Health Act 1983 is incapable of administering his property or managing his affairs, or
- qualifies under a 'benefits test', i.e:
- is in receipt of an increased disablement pension, or
- is in receipt of attendance allowance, or
- is in receipt of the care component of disability living allowance at the highest or middle rate, or the mobility component of disability living allowance at the higher rate, or
- is in receipt of a Personal Independence Payment, or
- is in receipt of an armed forces independence payment.
Qualification as a disabled person by being in receipt of only the mobility components of disability living allowance or personal independence payment came in for the year 2014/15 and later year as a result of changes by the Finance Act 2014.
The qualifying conditions for the ‘mental disorder’ test to be satisfied are less stringent than often thought. It is understood that 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;
- Autistic Spectrum Disorder (although normally described as a pervasive developmental disorder);
- Learning disability, such as those with Down’s syndrome.
Brain injuries per se are not a mental disorder because they may only have physical consequences (e.g. loss of movement, or muscle control). But psychological, cognitive or behavioural disorders associated with or caused by them are mental disorders.
Similarly, Parkinson’s per se 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 (e.g. dementia).
The benefits test
The benefits test (see above) is treated as satisfied 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.
Can you give me more details about the special income tax/capital gains tax treatment?
If the type of trust and beneficiary qualifies as described on our website here, the trustees and the beneficiary can jointly make a ‘vulnerable person election’ which then 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.
But the legislation uses a needlessly complex formula to achieve that result. Basically, one has to work out separately:
(a) what the vulnerable beneficiary’s tax liability would be if they received no income whatsoever from the trust (i.e. the trustees calculate the beneficiary’s income on the ‘normal’ basis), and
(b) what it would be if all trust income were included as the vulnerable beneficiary’s income (i.e. paid directly to them as an individual),
(c) then subtract (a) from (b), and
(d) subtract the result in (c) from the trustees’ liability as it would be without taking into account any relief available under these provisions.
The above formula works out the reduction in tax payable by the trustees. Capital gains tax relief is calculated in a similar way to the income tax relief.
There are variations on this theme for computing the relief from income tax and from capital gains tax depending on whether the beneficiary is UK resident or non-resident.
This calculation becomes even more complex if any of the income is actually paid over to a vulnerable beneficiary and in these circumstances the special tax treatment may not produce the lowest overall tax bill. Unsurprisingly, competent professional advice is needed to carry out any of these computations. See the introductory section for information on where to find such help.
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.
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 – i.e. 12 months after the 31 January following the end of the tax year in question (so 31 January 2021 for 2018/19).
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 are terminated. In any such case the trustees must inform HMRC.
While the election is irrevocable, the benefit can be opted into/out of each tax year (for it to apply, the irrevocable election must also be supplemented with a claim made through the tax return each year). Again, any person contemplating such a trust must engage the services of a professional skilled in the law and taxation of trusts, as the whole area is fraught with technical difficulty.
Can you tell me about the special inheritance tax treatment for disabled person’s trusts?
The observations throughout about the need for competent professional advice, are 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.
A ‘disabled trust’ is not subject to the ten-yearly charge or the exit charge, but is taxed as though the disabled beneficiary were entitled to the property in the trust in his or her own right. Hence 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 the trust comes to an end during his/her lifetime.
Please note that following representations by LITRG and other interested groups, from 5 December 2013 a potential double charge to inheritance tax and capital gains tax on the value of the trust assets on the death of the beneficiary was removed.
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.
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 (i.e. it must be a discretionary trust); and
- for property settled before 17 July 2013, if any trust property is applied for anyone’s benefit during the life of the disabled beneficiary, not less than 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, i.e:
- incapable by reason of mental disorder within the Mental Health Act 1983 of administering his property or managing his affairs, or
- is in receipt of an increased disablement pension, or
- is in receipt of attendance allowance, or is in receipt of disability living allowance care component at the highest or middle rate or mobility component at the higher rate, or
- is in receipt of the Personal Independence Payment, or
- is in receipt of an armed forces independence payment.
Where property was transferred into 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.
The definition also covers those who would be able to receive those benefits if they fulfilled the necessary residence requirements, or if they were not receiving outpatient treatment for renal failure or resident in a care home.
‘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 was negotiated by a Low Incomes Tax Reform Group-led coalition mainly of mental health charities and their advisers during the passage of the 2006 Finance Bill through the House of Commons. However, it only applies where the afflicted party settles the money themselves. 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.