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Philip Warford writes for the Private Client Section magazine, May edition
Philip Warford is managing director of Renaissance Legal, specialists in families and carers of disabled and vulnerable individuals
The Family Resources Survey 2016/17 tells us that there are 13.9 million people in the UK who are disabled. With the population of the UK at that time being just under 66 million, that means that just over 20% is disabled. The National Statistics 2017 also tell us that approximately 2.16% of adults and 2.5% of children are believed to have a learning disability. It is, therefore, almost guaranteed that we will all frequently meet a client who has a disabled or vulnerable relative.
Private client practitioners will usually advise a client about protecting assets for a disabled or vulnerable person in the context of an inheritance. That would usually be from a parent to a child, but you might also be approached by a grandparent wanting to protect an inheritance for a grandchild, or, more increasingly, by a spouse or partner for their spouse or partner
The starting point is to consider that leaving money directly to a disabled or vulnerable person could have a detrimental effect on their benefits and support package. Also, depending on the individual, the inheritance may increase their vulnerability, and a lack of capacity could cause problems in receiving the inheritance.
Benefits and vulnerability
Why do we need to protect benefits?
Benefits are split into two types, those which are means-tested, and those which are not. Some local authority support is also means-tested, particularly care costs. Means-tested benefits and local authority means-tested support are available to people who can demonstrate that their income and capital are below a certain level. It used to be easy to explain means-tested benefits by using housing benefit or income support as an example, but it is a bit more difficult now we have universal credit (UC).
UC is designed to pay for the everyday living expenses (eg rent, food, utilities and some service charges) of people with limited savings and income. The financial test is two-fold, looking at both income and capital. If someone has savings of more than £16k, they cannot claim UC. If their savings are lower, they can claim, but any savings or capital they have above £6k will affect the amount of UC they will be awarded. The income test is based on an assessment of what a person needs to live on, compared to what they have coming in. If the person’s income is insufficient, UC will make up the difference.You can see that any inheritance, be it capital or a right to income, paid directly to someone claiming, or due to claim UC in the future, would prejudice the claim and, in effect, be a waste of the inheritance.
What are the considerations with a vulnerable person?
Lots of our clients readily use the word ‘vulnerable’ when discussing their family member, and do not see it as a derogatory description. However, lately, I have spoken to a number of lawyers and charities which are avoiding using the word due to any negative connotations linked to it.
Whether you use the word or not, the meaning of ‘vulnerable’ is helpful to understand the type of person you are trying to protect, that is someone ‘exposed to the possibility of being attacked or harmed, either physically or emotionally’ and ‘(of a person) in need of special care, support, or protection because of age, disability, or risk of abuse or neglect’ (Google Dictionary definition).
What you do not want to do is make the disabled or vulnerable person more vulnerable than they already might be or, indeed, cause them additional emotional distress. Therefore, avoiding giving them a direct inheritance is usually thought to be the best action.
Capacity might also be considered when discussing vulnerability. Does the individual have the required level of capacity to be able to manage a direct inheritance? If not, by giving them a direct inheritance, are you putting them in a position in which someone will need to apply for a Court of Protection (CoP) deputy order to manage the inheritance on their behalf?
When thinking about capacity, you will also need to consider the capacity of the disabled or vulnerable person to give a receipt for the inheritance. If the beneficiary does not have the required level of capacity to do this, then, again, you may need to apply for a CoP deputy order to be able to give a receipt for the inheritance.
Which trust should you use?
A trust can be a useful tool to provide financial stability for someone throughout their lifetime and when the person caring for them is no longer around. The type of trust required will depend on the individual who needs to be protected, the flexibility required, and the value and type of assets involved. The two main options available are a discretionary trust and a disabled person’s trust, although it might also be worth considering, or indeed dismissing, an interest in possession trust.
Interest in possession (IIP) trust
An IIP trustis a type of trust in which at least one person has the right to receive the income from the trust (if trust funds are invested), or the right to enjoy the trust assets, without actually owning them.
The issues with using an IIP trust for a disabled or vulnerable person are that:
- the right to income and enjoyment of assets might prejudice means-tested benefits and local authority means-tested support
- paying income to a vulnerable person could cause them distress, anxiety and put them in a position where they could be taken advantage of
- where capacity is an issue, the trustees might have difficulties getting a receipt for the income paid.
We can, therefore, usually dismiss the IIP trust as an option when considering provision for a disabled or vulnerable person. However, if the trust fund is small and the individual has capacity, an IIP trust might be worth considering.
In a discretionary trust, the trustees have full discretion to use the assets in any way to meet the needs of any of the beneficiaries, at any time.
It is usual to have several beneficiaries of a discretionary trust, which will include the disabled or vulnerable person and at least one default beneficiary.
None of the beneficiaries have any right to receive assets from the trust. The beneficiaries only have a potential to benefit if the trustees choose to exercise their discretion in a person’s favour.
The trustees can make decisions to meet the changing requirements of the disabled or vulnerable person during their lifetime. The trustees can use their discretion to use any amounts of capital or income for the beneficiaries, depending on their needs.
A discretionary trust can last for up to 125 years by virtue of the Perpetuities and Accumulations Act 2009. However, what usually happens is that, on the death of the disabled or vulnerable person, the trust is wound up or closed, and any assets left paid to the other beneficiaries of the trust in accordance with a letter of wishes left with the trust deed.
It might be useful to draft the trust deed so that the trust does not automatically come to an end when the disabled or vulnerable person dies. This would give a degree of flexibility to the trustees to carry on the trust if, for example, there are young beneficiaries or other beneficiaries who are disabled or vulnerable
Assets held in a discretionary trust are disregarded when it comes to claiming means-tested benefits and local authority means-tested support. The Department of Health and Social Care’s care and support statutory guidance (tinyurl.com/l9rb48v) (last updated on 26 October 2018), at annex B (treatment of capital), section 58 states: ‘In some instances a person may need to apply for access to capital assets but has not yet done so. In such circumstances this capital should be treated as already belonging to the person except in the following circumstances: (a) capital held in a discretionary trust.’ (The other circumstances are not relevant to this article.)
The statutory guidance is supported by the House of Lords decision in Gartside v Inland Revenue Commissioners AC 553, which, despite being 50 years old, is still relevant law. In this case, Lord Reid said ‘no object of a discretionary trust has, as such, any legal right to or in the capital … a right to require trustees to consider whether they will pay you something does not enable you to claim anything. If the trustees do decide to pay you something, you do not get it by reason of having the right to have your case considered: you get it only because the trustees decided to give it to you.
For the purposes of protecting vulnerability and capacity issues, the trustees’ flexibility in using income and capital means that they can use this in any way that benefits the disabled or vulnerable person, without having to transfer assets to them.
Disabled person’s trust
For administration purposes, a disabled person’s trust operates in the same way as a discretionary trust. The trustees have flexibility to advance income and capital to the beneficiaries in any way that the trustees decide.
The main benefit of using a disabled person’s trust over a discretionary trust is down to the special tax treatment it receives (see below).
To set up a disabled person’s trust, you will need a primary beneficiary, ie the disabled or vulnerable person, who must be deemed to be ‘disabled’.
By virtue of section 89(4A) of the Inheritance Tax Act 1984 (IHTA 1984) and section 38 of and schedule 1A to the Finance Act 2005, a disabled person is defined as someone who is:
- incapable of administering their property or managing their affairs by reason of mental disorder within the meaning of the Mental Health Act 1983 or
- in receipt of attendance allowance (AA) (or constant attendance allowance) or
- in receipt of disability living allowance (DLA) by virtue of entitlement to the care component at the higher or middle rate, or the mobility component at the higher rate, or
- in receipt of personal independence payment (PIP) at the standard or enhanced rate for either of the daily living activities or mobility components or
- in receipt of an increased disablement pension or
- in receipt of armed forces independence payment or
- would be in receipt of AA, DLA (at the relevant levels) or PIP if not for specified reasons, such as being in hospital or failing to satisfy prescribed conditions as to their residence or presence in the UK.
It is important to note here that notwithstanding that you are ‘separating out’ the disabled or vulnerable person and giving them ‘special’ treatment in this type of trust, it is, still, discretionary. The disabled or vulnerable person does not have the right to receive assets from the trust, so means-tested benefits and local authority means-tested support should not be prejudiced by using this type of trust, and you are protecting against the vulnerability and capacity issues.
Although a discretionary trust works to protect the benefits, vulnerability and capacity considerations mentioned above, it is a relevant property trust for tax purposes and is subject to a number of taxes.
Income tax is charged at 38.1% on dividend income and 45% on all other income. The first £1k of income is taxed at the standard rate unless the settlor has more than one trust, in which case the £1k is divided between the trusts.
Capital gains tax (CGT) is charged at 28% for disposals of residential property and 20% for other disposals, with the trustees only being entitled to one half of the annual exemption. Lifetime gifts into a discretionary trust are disposals for CGT. However, due to the rules on inheritance tax (IHT) (see below), the settlor can claim hold-over relief under section 60 of the Taxation of Chargeable Gains Act 1992 on any lifetime gift into a discretionary trust
A lifetime gift into a discretionary trust is a chargeable lifetime transfer. This would trigger an immediate IHT charge of 20% on the value in excess of the settlor’s available nil-rate band (NRB). For the trust itself, there will be an IHT charge at each 10-year anniversary of the creation of the trust (known as the periodic charge) at a maximum rate of 6% of the value of the assets held. There will also be an exit charge at a maximum rate of 6% where assets are appointed out of the trust, either before or after the periodic charge. HM Revenue & Customs’ (HMRC) guidance on trusts and IHT (www.gov.uk/guidance/trusts-and-inheritance-tax) admits that both calculations are ‘complicated’!
The other important point here is that the residence NRB (RNRB) does not apply to gifts on death to a discretionary trust, even if all beneficiaries are lineal descendants.
To make the income tax situation seem slightly better, remember that if the income is appointed out to a beneficiary, the beneficiary will also receive a tax credit for the income tax paid by the trust. Therefore, the beneficiary could reclaim some or all of the income tax depending upon the beneficiary’s personal income tax rate.
Disabled person’s trust
The tax treatment of a disabled person’s trust is much more favourable.
A disabled person will usually be treated as a ‘vulnerable person’ for income tax and CGT purposes. The trustees will therefore be able to elect for vulnerable person’s tax treatment on HMRC form VPE1. This means that the amount of income tax and CGT which the trustees pay each year is no more than it would have been had the income or gains arisen directly to the disabled person. Also, due to the IHT treatment of the trust, there will be a CGT uplift on the death of the disabled person.
The trust is deemed to be a qualifying IIP for IHT purposes, even though for administration purposes the disabled person has no actual IIP. This means that the period and exit charges are avoided. When the disabled person dies, the value of the assets is aggregated with their assets, and IHT calculated on that basis. Also, gifts into the disabled person’s trust are potentially exempt transfers and the IHT RNRB on death is preserved where the gift is to a disabled person’s trust.
For IHT, the relevant condition applies at the time when assets are transferred to the trust. For a will or codicil, this will be when the testator dies. For lifetime trusts, it will be when assets are transferred into the trust.
For income tax and CGT, the relevant condition must apply for the whole of the tax year in which the income arises or chargeable gain accrues.
Clearly, the government would not give such favourable treatment without imposing a limitation. In this case, to keep within the vulnerable person’s tax regime for income tax and CGT purposes, the trustees must not pay out the lower of £3k, or 3% of the maximum value of the trust fund, in any tax year to the non-vulnerable beneficiaries.This is in total to all non-vulnerable beneficiaries, and not the amount to each non-vulnerable beneficiary.
When the disabled or vulnerable person dies, the trust will convert to the tax treatment of a discretionary trust. The trustees will, therefore, need to be careful about what assets are held, so as to avoid the rather penalising income tax and CGT rates of a discretionary trust.
Which trust to use?
As you can see, the main advantage of a disabled person’s trust over a discretionary trust is the favourable tax treatment that it receives. If the disabled or vulnerable person meets the relevant condition for a disabled person’s trust, then a direct comparison of the differences between both types of trust and the implications for the disabled or vulnerable person and their family needs to be made.
There are a number of factors to consider:
- the age of the disabled or vulnerable person
- the nature of their disability or vulnerability
- their long-term health prognosis
- the value and type of assets the person setting up the trust wishes to place into the trust
- the potential tax liabilities
- the needs of the disabled or vulnerable person – for example, where they may live, who will care for them, how this will be funded and what the settlor wishes the trustees to use the trust fund for
- the needs of other family members
- who will take the fund when the disabled or vulnerable person dies.
A discretionary trust may be more suitable where the tax implications are limited because, for example, the value of the fund is low, the assets are not producing high income or gains, or maximum flexibility is required to provide for other people. A disabled person’s trust may be more suitable where tax is likely to be a significant problem and there is no great need to provide for others during the lifetime of the disabled or vulnerable person.
Choice of trustees
One of the hardest decisions to make when creating trusts to protect assets for a disabled or vulnerable person is choosing trustees. Trustees are likely to need help in managing the trust and will need to work closely with the disabled or vulnerable person or their care team. Trustees will need to do things which ‘typical’ trustees do not usually have to do, such as:
- consider the benefits package that the disabled or vulnerable person is receiving
- review capacity
- consider the short-term and long-term health issues of the disabled or vulnerable person
- be proactive in making sure that they use the trust fund in a way that ensures the disabled or vulnerable person remains safe.
The settlor ought to also consider whether trustees can be included in the trust deed as beneficiaries, or if this puts them in a conflict position. If, for example, the trustees are also the beneficiaries and will benefit on the death of the disabled or vulnerable person, could they refuse to advance income and capital in the knowledge that they will receive the capital in time?
Selecting the beneficiaries
Special consideration needs to be given to the default beneficiary, as quite often the settlor would like to benefit charities who have helped them following the death of the disabled or vulnerable person. Also, the power to add and remove beneficiaries might be important to enable the trustees to be responsive to any important changes in the life of the disabled or vulnerable person.
Powers of the trustees
Some other things worth special consideration include:
- tying a disabled person’s trust to changes in the law, specifically section 89 of the IHTA 1984
- all the powers of investment and delegation, as the trustees might need assistance in performing their duties and responsibilities
- the power to pay professional trustees
- the power to appoint to a new trust, in case the law should change
- whether or not the trust should come to an end on the death of the disabled or vulnerable person.
Letter of wishes
This becomes a very important document where the main purpose of the trust is to provide for a disabled or vulnerable person. You should spend time with your client finding out about the disabled or vulnerable person’s needs, what they like doing, their current care package and what aspirations the settlor has for them. You should then encourage the settlor to keep the letter of wishes under review, possibly annually, to ensure that it is kept up to date for when the settlor is no longer around.
Other practical points
What happens if the beneficiary is no longer disabled or vulnerable?
This point might come up if, for example, someone has an acquired injury which they could recover from. At the point of injury, they could be disabled and/or vulnerable, but that may change, should they recover. This is unlikely to come up in the context of someone with a disability or vulnerability from birth, but nevertheless, it is good to cover this with your client.
Most discretionary and disabled person’s trust deeds are drafted in a way in which income and/or capital can be advanced to the disabled or vulnerable person at any time, even if this exhausts the whole fund. In the case of a disability or vulnerability which the person might ‘recover’ from, the settlor’s thoughts on winding up the trust can be documented in the letter of wishes.
Deeds of variation
A deed of variation redirects assets from the beneficiary to someone else. It is a lifetime gift irrespective of whether it is made by the beneficiary themselves or someone on their behalf. Therefore, the gift could get caught by the deliberate deprivation of assets rules for means-tested benefits and local authority means-tested support purposes, if a ‘significant operative purpose’ for entering into the deed is to enable the beneficiary to continue claiming benefits. Guidance can be found in the Department for Work and Pensions’ Decision makers’ guide (tinyurl.com/yxoqajjf), volume 5, chapter 29, paragraph 29805 and following, with paragraph 29817 specifically stating that entering into a deed of gift could be deemed deliberate deprivation.
The moral of the story here is that if the person who has died could have done something themselves and did not, even if they did not know what they could have done, then in this context you cannot correct it by using a deed of variation.
The CoP is fully aware of this, and will not authorise an inheritance being paid into a trust just because of the loss of means-tested benefits or local authority means-tested support.
What should you do?
With diagnosis of disabilities and vulnerabilities vastly improved, and life expectancy continuing to rise, you will need to make yourself aware of the options available to the families that you work with. This will show that you care for your clients and their relatives, which will make your clients feel confident in the service that you are providing.