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Trusts for disabled persons – to elect or not to elect  

23 April 2018

There are available tax advantages on electing for a trust to be treated as a vulnerable person’s trust but is it always the best thing to do for a disabled beneficiary? Helen O’Hagan, technical helpline manager, Prudential looks at the details.

Who is a vulnerable beneficiary?

A ‘vulnerable beneficiary’ is either:

  • A person who is mentally or physically disabled; or
  • Someone under 18 – called a ‘relevant minor’ – who has lost a parent through death.

This article only deals with a person who is mentally or physically disabled. That person will be eligible for any of the following benefits (even if not received):

What is a qualifying Trust?

Income and Capital Gains Tax: for a trust to be ‘qualifying’ its assets must only be capable of being used to benefit a disabled person. The disabled person must be entitled to all the income or, if they are not so entitled (because there is no interest in possession), none of the income can be applied for the benefit of anyone else.

Inheritance tax (IHT): for a trust to be ‘qualifying’ it must be for a disabled person. Where the  trust was set up before 8 April 2013, at least half of the payments from the trust must go to the disabled person during their lifetime

For a disabled person whose trust was set up on or after 8 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

What is the special tax treatment?

If the trustees have completed the vulnerable persons election for a qualifying beneficiary, the trust will receive favourable tax treatment.

In respect of Income Tax and Capital Gains Tax the trustees are entitled to a deduction of tax against the amount they would otherwise pay. This is calculated as follows –

  1. The trustees calculate their tax liability on the ‘normal’ basis
  2. They then calculate the tax the vulnerable beneficiary would have had to pay if the trust monies had been paid directly to them as an individual
  3. The trustees then claim the difference between these two figures [ie (a) – (b)] as a deduction from their own tax liability

In respect of inheritance tax, there is none if the person who set up the trust survives seven years from the date they set it up or on transfers made out of a trust to a vulnerable beneficiary.

When the beneficiary dies, any assets held in the trust on their behalf are treated as part of their estate and inheritance tax may be charged.

The normal tax rules for relevant property do not apply to the vulnerable beneficiary trust, therefore the transfer in is a potentially exempt transfer and drops out of the cumulation, after 7 years. There will not be any 10 yearly charges, nor do exit charges apply, to the trust.

Be careful when distributing the trust fund

If a beneficiary is disabled, they may be in receipt of means tested benefits and perhaps a Local Authority care package, e.g. they may have carers who take care of them, on a day-to-day basis.

If a beneficiary receives income or capital from a trust, above certain limits, the Local Authority may assess their ability to contribute and any means tested benefits or care package may be reduced or withdrawn.

It makes sense for the trustees to purchase items required by the disabled beneficiary or pay for holidays etc direct from the trust in order that they do not count towards any benefits.

What if you can’t or don’t want to make a vulnerable person’s election?

Individuals may want to consider setting up a standard discretionary trust. The discretionary trust normally has a wide class of beneficiaries and it’s up to the trustees to decide to whom and when any payments are made. It is advisable for clients to choose their  trustees wisely as ultimately they will be dealing with the trust fund. It also makes sense for clients to write a letter of wishes to the trustees to give them guidance, after their death, as to the aim of the trust fund.

Under a discretionary trust there is no entitlement by any of the beneficiaries to income or capital. Therefore, there will be no impact on the benefits and care package that a disabled beneficiary receives, unless the trustees make direct payments to them.

A discretionary trust also allows the trustees flexibility on death of the disabled individual as to who will now receive the trust assets and they will not form part of the disabled beneficiary’s estate.

Summary

Individuals who are considering setting up a trust for a disabled beneficiary will have to weigh up the tax advantages of the vulnerable persons election compared to the potential loss of means tested benefits or local authority funded care packages if certain limits are breached due to the disabled beneficiary’s entitlements – especially if the beneficiary is young where the costs borne by the Local Authority may be extensive.

With regard to a standard discretionary trust, if the transfer into trust does not breach the individual’s nil rate band, when added to any previous transfers into discretionary trusts set up in the previous 7 years there will be no entry charge on setting up the trust. If the value of the trust fund is below the available nil rate band at the 10 year point there will be no periodic charge.

If the assets inside the discretionary trust do not produce any income, the trustees will not have to submit a tax return until a tax consequence is realised, thus using an investment bond can be a very tax efficient investment for trustees.

The flexibility of the discretionary trust may outweigh the tax advantages of the vulnerable persons election but each case will have to be assessed on its own merit.

 

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