Understanding tax treatment of trusts for disabled people
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 the 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).
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. For most trusts, tax is chargeable at least once every ten years and also when property leaves the trust. 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.
Historically, governments and HMRC (and the Inland Revenue before them) have seen trusts as primarily a tax avoidance vehicle and have consequently imposed higher rates of taxation 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 37.5% on dividend income, which equate to the highest rates applicable to individuals. If and when the income is distributed to individual beneficiaries, the trustees supply a form R185 showing how much tax has been deducted, 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 (£5,450 as opposed to £10,900, for 2013/14) and are chargeable to tax on gains above that amount at a rate of 28%, equal to the higher of the two rates payable by individuals.
Tax treatment of trusts for people with disabilities – introductory
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, and to ensure that for inheritance tax the 10-yearly tax charges that affect most other trusts do not apply.
Vulnerable trusts – special income tax and capital gains tax treatment
For income tax and capital gains tax, the special tax treatment was introduced in 2005. Its scope includes trusts not only for disabled beneficiaries (as defined) but also for beneficiaries under the age of 18 at least one of whose parents has died. This commentary will deal with the vulnerable trust rules only to the extent that they apply special tax treatment to trusts for disabled beneficiaries.
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 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 to the extent permitted by the general law, which override any provision in the trust deed.
For this purpose a disabled beneficiary 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
- Is in receipt of attendance allowance or of the care component of disability living allowance at the highest or middle rate (note the mobility component of disability living allowance is not included).
There are proposals in the 2013 finance bill to vary these conditions: see separate section below.
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;
- Autism (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 (eg 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 (eg dementia).
The benefits test
The benefits test (receipt of attendance allowance or of disability living allowance care component at the highest or middle rate) 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;
- they are residing in a care home where the cost of their accommodation, board and personal care is borne out of public funds.
The special tax treatment
If the type of trust and beneficiary qualifies as described above, the trustees and the beneficiary can jointly make a ‘vulnerable person election’ which 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. 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, and
- (b) what it would be if all trust income were included as the vulnerable beneficiary’s income,
- (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.
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. Unsurprisingly, competent professional advice is needed to carry out these computations.
Vulnerable person election
An election is made for a tax year or part of a tax year. It has to be made within 12 months of the end of the tax year for which it is to have effect. 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.
Again, any trustee 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.
Inheritance tax and disabled person’s trusts
The observations above about the need for competent professional advice are even more apposite when the quite different rules for disabled person’s trusts for inheritance tax are added into the mix, especially where it is intended to take advantage of both regimes.
Taxation of ‘disabled trusts’
Most trusts are subject to an inheritance tax regime that involves:
- a charge on all property over £325,000 in value in the trust at each ten-year anniversary of the setting up of the trust;
- a separate charge on any property being taken out of the trust in between ten-year anniversaries (an ‘exit charge’).
The rate of tax on the ten-yearly charge is 30% of the lifetime rate of IHT which is 20% ie a maximum rate of 6%, and on the exit charge 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. The intention is that every trust should suffer approximately 40% tax every 70 years.
A ‘disabled trust’, on the other hand, 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 tax only when the beneficiary dies or the trust comes to an end during his/her lifetime.
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 (ie it must be a discretionary trust); and
- 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.
If both of those conditions are satisfied, then the disabled beneficiary is treated as though they did have a life interest in the trust property, thus enabling it to be taxed in the way intended – tax on the death of the disabled beneficiary and on any cessation of his/her interest during his/her lifetime, but the ten-year and exit charge regime does not apply.
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 (see above) – either:
- incapable by reason of mental disorder within the Mental Health Act 1983 of administering his property or managing his affairs, or
- in receipt of attendance allowance, or of disability living allowance care component at the highest or middle rate. The 2013 finance bill contains proposals to add any one in receipt of the daily living component of personal independence payment (PIP) at either rate (see below).
As in the context of vulnerable trusts, the definition also embraces 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 in receipt of an attendance allowance or disability living allowance care component at the highest or middle rate. 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 was negotiated by a LITRG-coalition mainly of mental health charities and their advisers during the passage of the 2006 Finance Bill through the House of Commons. It is, however, of limited 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.
Changes in prospect – Finance Bill 2013
There are proposals in the 2013 finance bill to:
(a) extend eligibility for disabled or vulnerable trust treatment to cases where the beneficiary is in receipt of an armed forces independence payment, or a personal independent payment (PIP) through being entitled to the daily living component at either the enhanced or the standard rate; and
(b) impose a limit of £3,000 in any year, or if less up to 3% of the maximum value of the trust property in the year, on trust funds or income that may be applied for any purpose other than the benefit of the disabled or vulnerable beneficiary during his or her lifetime.
It is unfortunate that, despite reform of the taxation of trusts in 2005 and 2006, the definition of disabled person was not looked at properly on either of those occasions, despite a consultation during which LITRG and other bodies pointed out that it failed to cover adequately all disabled people who needed, because of their disability, to use trusts. Since 2006 it has become common to use bare trusts where possible, instead of disabled trusts – but that is never a good solution if there is a risk the beneficiary may be exploited or manipulated, for example by other less scrupulous family members.
Since then, the extent of the mental disorder limb of the definition has been clarified (see above) and this will have gone some way to allaying fears previously expressed that it may have been too narrowly targeted.
A useful exercise now would be to iron out the many inconsistencies between the regimes for vulnerable trusts for income tax and capital gains tax, and disabled trusts for inheritance tax, so that the two are compatible.