• A trust for a vulnerable beneficiary is taxed differently to normal trusts.

• There are income tax, capital gains tax and inheritance tax advantages for qualifying trusts for vulnerable beneficiaries.

• The qualifying criteria is the same for income tax and capital gains tax, but the qualifying criteria for inheritance tax is different.

The UK tax code usually refers to trusts for “vulnerable beneficiaries” rather than trusts for the disabled.

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.

They are eligible for any of the following benefits (even if they don’t receive them):

• Attendance Allowance
• Disability Living Allowance (either the care component at the highest or middle rate, or the mobility component at the higher rate
• Personal Independence payment
• An increased disablement pension
• Constant Attendance Allowance
• Armed Forces Independence payment

If a trust is set up for a vulnerable beneficiary, the trustees can claim special treatment for income tax and capital gains tax (CGT) if it is a ‘qualifying trust’.

For a trust to be 'qualifying’ (relating to income tax and CGT. There is a separate criteria for inheritance tax (IHT) – outlined below), its assets must only be capable of being used to benefit a disabled person (there is though very limited scope for others to benefit). 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. If only part of a particular trust meets the vulnerable person criteria, then the special income tax treatment may only apply to that part if it is held in a separate fund or in some other way as a defined part.

To claim special tax treatment for income tax and CGT, the trustees must complete form VPE1 (Vulnerable Person Election) and send it to HMRC.

The trustees must sign VPE1 along with the vulnerable beneficiary (or with someone who can legally sign for the beneficiary).

A separate form VPE1 must be completed for each beneficiary.

The special tax treatment takes effect from the date provided (elected for) on form VPE1. The election must be made no later than 12 months after 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 special tax treatment is no longer effective after the death of the vulnerable beneficiary or the date on which the vulnerable beneficiary ceases to be vulnerable.

Where a trust has a vulnerable beneficiary, 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 income tax liability on the ‘normal’ basis (this varies according to which type of trust it is).
2. They then calculate the income tax the vulnerable beneficiary would have had to pay if the trust income had been paid directly to them as an individual.
3. The trustees then claim the difference between these two figures [i.e. (a) - (b)] as a deduction from their own income tax liability.

CGT is payable by the trustees. They can claim a relief calculated in a similar way to the income tax relief:

• The trustees calculate the CGT as if there was no reduction.
• The trustees then calculate the CGT if the gains arose directly to the vulnerable beneficiary.
• The trustees can claim the difference between these two amounts as a reduction.

This special treatment does not apply in the tax year when the beneficiary dies.

Trusts for vulnerable beneficiaries get special inheritance tax treatment if they are ‘qualifying trusts’.

A qualifying trust for a disabled person is one where:

• For a disabled person whose 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.
• When someone suffering from a condition that’s expected to make them disabled, sets up a trust for themselves.

There’s no IHT charge:

• If the person who set up the trust survives seven years from the date they set it up. If you set up a disabled trust for someone else, that qualifies as a 7 year PET.
• 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 IHT may be charged. Although it’s a discretionary trust, for IHT purposes, the disabled beneficiary is treated as having an Interest in Possession. No 10 yearly or exit charges apply but instead an IHT charge arises when the beneficiary dies or if the trust comes to an end during their lifetime. 

On 7 November 2018, HMRC issued a consultation document “The Taxation of Trusts: A review”. In simple terms, the consultation sets out the government’s thinking on making trusts fairer, simpler and more transparent. At the time of writing, the government is not making specific proposals for reform. Instead, the government will weigh up the views and evidence presented and consider the options for targeted reforms. 

On 23 November 2018, the Office of Tax Simplification published its First Report regarding its review of the IHT regime. This concluded that too many people have to fill in IHT forms, with the process being complex and old fashioned. The recommendations therefore relate to administrative issues. The second report covering wider areas of concern (technical and design issues) was published in July 2019