Establishing a trust for a vulnerable or disabled individual
Steve Hennessy – Chartered Financial Planner
Establishing a trust for a vulnerable or disabled individual is often considered by families keen to provide for their loved ones.
If an individual does not have the capacity to manage their own financial affairs, and there is no registered power of attorney, gifting funds into a trust for the benefit of the individual (rather than directly to the individual) may be worth considering for several reasons, but trusts can be complicated arrangements.
Here, we outline the typical, broad issues for trustees and settlors in such circumstances.
Professional advice should be sought and considered before taking any action.
Trusts – the basics
Unlike Deputyships or Lasting Powers of Attorney where individuals manage a vulnerable individual’s financial affairs on their behalf, a trust is a separate legal arrangement with its own tax status and rules.
It can be helpful to think of a trust as a ‘wrapper’ in which can be held assets such as cash, investments, property and so on, rather than those assets being owned by an individual.
The person who puts the asset into the trust is called the settlor. The trustees manage the trust and the asset(s) within it, for the benefit of the trust beneficiary/ies.
A trust deed is a legal document that lays out who the trustees and beneficiaries are, as well as how the settlor intends the trust assets to be used. Typical scenarios include an income from the assets being paid regularly to a beneficiary, or a capital amount paid out on a beneficiary reaching a certain age.
A disabled trust may be created through the Will of someone wishing to benefit a disabled or vulnerable friend or relative, or by a lifetime gift of cash or assets.
A settlor may choose a disabled trust for one of the following reasons:
- 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.
Special tax treatment is available for certain trusts which are created for a disabled person.
- Disabled trusts are not subject to Inheritance Tax periodic and exit charges.
- The full annual Capital Gains Tax exemption is available.
- Income can benefit from the beneficiary’s tax allowances and rates.
To obtain the special tax treatment the trust must benefit either a disabled person or a bereaved minor.
- In this context, whether an individual is a disabled person is generally determined by their 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.
While there can be positive tax outcomes, a settlor will need to decide whether the potential tax benefits outweigh the added complexity and restrictions on who can benefit.
A normal discretionary trust can be just as effective in meeting the trust objectives whilst providing greater flexibility, particularly if tax is not an issue.
A qualifying disabled person’s trust will avoid the entry charge, the 10-yearly ‘periodic ‘charge, and exit charges applicable to ‘no-disabled’ discretionary trusts. A lifetime transfer into a qualifying disabled person’s trust is instead treated as a potentially exempt transfer (PET) from an inheritance tax perspective, and therefore unlimited amounts can be settled, provided the settlor survives the gift by 7 years.
The value of the gift may be aggregated with the value of the settlor’s estate on their death if it is within 7 years of the gift, possibly increasing the amount of tax payable on their estate. However, it is possible to insure against this risk and the cost is usually relatively inexpensive, depending primarily on the settlor’s state of health.
Inheritance Tax (IHT) at 40% may be payable on the death of the disabled beneficiary if their capital interest in the trust, combined with their other assets, is in excess of their available nil rate band.
Income Tax and Capital Gains Tax
From an income tax point of view, the use of a disabled person’s trust will usually result in a lower level of taxation than a comparable, ‘non-disabled’ discretionary trust. Discretionary trusts pay income tax at up to 45% (‘the rate applicable to trusts’ [RAT]), although the rate is broadly 20% on the first £1,000 of income.
For capital gains tax purposes, the issue confronting trustees centres on whether the most appropriate outcome is to obtain a full annual capital gains tax exemption (which disabled person’s trusts are entitled to) or hold-over relief (which they are not).
Consideration must also be given on whether to satisfy the conditions of transparency for the relief available to a vulnerable person’s trust. Whether the relief is worthwhile given the extra administration, and the restrictions the relief imposes on the trustees’ powers to appoint trust funds, will vary from trust to trust.
The right trust can be an effective way of ring-fencing and preserving property for those in receipt of means-tested benefits. Outright gifts of capital (beyond a small amount) to any person claiming means-tested benefits may well compromise those benefits.
For those in receipt of trust income, that income could inadvertently result in the withdrawal of means tested benefits.
Capital can instead be settled into a trust and the settlor may direct the trustees to accumulate any income, leaving the decision as to what to do with the trust property to the trustees, within certain parameters to protect the interests of the beneficiary. Capital and accumulated income held in the trust should not compromise the vulnerable person’s state benefits.
Whilst use of a trust may be an advantage, use of a qualifying disabled person’s trust is not always the most tax efficient solution when the age and circumstances of the beneficiary are fully considered.
Trust taxation is a complex area and professional advice should be sought where appropriate. The following resources provide more information and guidance on trusts and investments generally.
If you’d like to talk about any element of this article please contact us.
Tax treatment is based on individual circumstances and may be subject to change in the future.
The Financial Conduct Authority does not regulate tax planning.