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Disabled trusts and trusts for vulnerable beneficiaries

Trusts are a useful vehicle to protect the interests of vulnerable beneficiaries. There is special tax treatment for certain trusts which are created for a disabled person or a bereaved minor.

A disabled trust benefits from special tax treatment provided certain conditions are met over who can benefit.

• Disabled trusts are not subject to IHT periodic and exit charges
• A full annual CGT exemption is available rather than the lower trust exemption
• Income can benefit from the beneficiary’s tax allowances and rates.

The rules are complex and will require specialist advice.

A disabled trust may be created through the Will of someone wishing to benefit a disabled or vulnerable friend or relative. Alternatively, the disabled trust could be created by a lifetime gift of cash or assets.

Reasons for using a disabled trust

There are several reasons why a settlor may choose a trust if there are vulnerable or disabled beneficiaries. For example:

• To make gifts to individuals who are unable or not trusted to manage their own affairs
• To protect vulnerable beneficiaries from the risk of financial abuse from third parties
• To protect entitlement to means-tested state benefits
• To benefit from a tax-favoured status compared to other trusts

The settlor will need to decide whether the potential tax benefits are worth the added complexity and restrictions on who can benefit. A normal discretionary trust could be just as effective in meeting the trust objectives whilst providing greater flexibility, particularly if tax is not an issue.

Impact on means tested benefits

Some vulnerable or disabled beneficiaries may be in receipt of means tested state benefits or local authority care packages. The trustees should consider the impact on these benefits when making payments to the beneficiary. A payment from the trust could mean the beneficiary’s capital or income exceeds means testing thresholds and could lead to the loss or reduction of means tested benefits.

The trustees may consider purchasing items for the disabled beneficiary directly from the trust so they won’t impact on means tested benefits.

Taxation

To obtain the special tax treatment the trust must benefit either a disabled person or a bereaved minor.

• A disabled person is someone who is mentally or physically disabled. This is generally determined by eligibility for certain state benefits such as attendance allowance, disability living allowance at the middle or higher rate or personal independence payment.
• A bereaved minor is a child who is under 18 and has at least one parent that has died.

Inheritance tax

Qualifying trusts won't be subject to relevant property charges. Gifts into these trusts will be a PET and there will be no periodic and exit charges. These IHT benefits will apply where:

Trusts created after 6 April 2013

• All payments must go to the disabled person, except for up to £3,000 per year (or 3% of the assets, if that's lower) which can be used for someone else's benefit
• A bereaved minor must become absolutely entitled at no later than age 18. This would apply if a minor child inherits under the laws of intestacy following the death of one of their parents

It's now possible for someone to set up a qualifying trust for themselves if they're suffering from a condition that is expected to make them disabled.

Trusts created before 6 April 2013

• At least half of the payments from the trust must go to the disabled person during their lifetime.

Income tax and CGT

Disabled trusts get a full CGT exemption and can also make a vulnerable person election to have income and capitals gains assessed at the beneficiary’s own rates of tax.

To qualify for preferential income tax and CGT treatment, the trust must allow the following:

• The property can be applied for the benefit of the vulnerable person, and
• Either the vulnerable person is entitled to all the trust income or, income cannot be applied for the benefit of anyone else

There are additional qualifying criteria for trusts for bereaved minors:

• The trust must be created by the parents will, under the laws of intestacy or under the Criminal Injuries Compensation Scheme
• The beneficiary becomes absolutely entitled at age 18

A qualifying trust gets the benefit of a full CGT annual exemption rather the half exemption which normally applies to trusts.

Also as the trust is not relevant property it means that, on the death of the disabled beneficiary, there's no CGT payable and the trustees acquisition costs are uplifted to the market value at death. As a result gains are effectively wiped out on death.

Vulnerable person election

In addition to getting the full CGT exemption the trustees can make an election so that they pay no more income tax or CGT than the vulnerable beneficiary would have to pay. This is not given automatically and the trustees must make a vulnerable person election to HMRC for it to apply.

A vulnerable person election is a one-off election using form VPE1. The tax reclaim is made via the trust annual tax return. The election applies to both income tax and capital gains tax. It has to be made within 12 months of the 31 January following the tax year when it is to start.

Any income or gains before the election takes effect are taxed under normal trust rules - even if the election takes effect part way through the same tax year.

The election is irrevocable, but ceases to be effective after the death of the vulnerable beneficiary, the trust being wound up or the beneficiary ceasing to be vulnerable. The trustees must inform HMRC of these events.

The trustees pay tax on income and gains at the same rates as if they arose directly to the vulnerable beneficiary. However, they're not taxed directly on the beneficiary.

The trustees still need to calculate their tax liability on income and gains as normal but can then deduct the difference between this figure and what the beneficiary would have paid as a deduction.

1. Trustees work out what their trust tax would be on income and gains if there was no claim for special treatment - for income, this will vary according to which type of trust it is.
2. They then work out what tax the vulnerable person would have paid if the income and gains had been taxed on them as an individual.
3. They can then claim the difference between these two figures as a deduction from their own tax liability via the trust tax return.

Personal injury trusts

A Personal Injury Trust is a trust created by an individual who has been awarded a compensation payment as a result of a personal injury. The injured party must be a beneficiary of the trust.

However, it's the source of the trust funds, not the type of trust, which makes it a personal injury trust.

A personal injury trust may be set up as an absolute, interest in possession or discretionary trust. They may even qualify as a disabled trust provided it satisfies the conditions on who may benefit.

Reasons for setting up a personal injury trust

A key reason for setting up a personal injury trust is to prevent the award causing a loss of means tested benefits. Personal injury trusts are disregarded in the means test for most means-tested state benefits, ancillary benefits such as free prescriptions and local authority support.

It's important that only personal injury payments are in the trust and money from other sources should not be added to trust.

Other reasons for establishing a personal injury trust might include inexperience of dealing with large sums of money, protection from unwelcome influence or the comfort of having experienced trustees to assist. A trust is also required if the claimant is a minor or mentally incapable unless a deputy has been appointed to look after their affairs.

Taxation

Personal injury trusts are not created for tax planning purposes and don't offer any special tax breaks unless they also qualify as disabled trusts.

The tax treatment will depend on the type of trust used and whether it qualifies as a disabled trust.

The injured person is deemed to be the settlor of the trust. This means the trust will be settlor interested for both income tax and CGT. It will also mean the trust will form part of the injured person’s estate for IHT.

Discretionary and Interest in possession trusts

Income will be assessed on the injured person as settlor of the trust for discretionary and interest in possession trusts. However, the trustees must pay the tax and credit is given to the settlor for the tax deducted by the trustees. For discretionary trusts, tax will be deducted at 45% (39.35% for dividends ) and for interest in possession trusts the rate is 20% (8.75 % for dividends). 

Capital gains on settlor interested trusts remain assessable upon the trust with trust rates and exemptions.

Absolute (Bare) trusts

The settlor interested trust rules don't apply to absolute trusts. All income and capital gains will be assessed upon the injured person as the absolute beneficiary.

Bond gains

There are separate trust taxation rules for investment bonds held in trust. For personal injury trusts the injured person will always be assessable upon any gain either as settlor for discretionary and interest in possession trusts, or as the beneficiary of an absolute trust.