Trusts for vulnerable and 'injured' beneficiaries"
The UK tax system offers tax ‘breaks’ to trusts for vulnerable beneficiaries. It is critical that advisers understand who can benefit, how these tax advantages work, and the implications for trustee investment.
Here are 10 important facts regarding this very important area of tax law.
What is a vulnerable person?
A vulnerable person is either a disabled person, defined here, or a child under the age of 18 at least one of whose parents has died. The child is called a ‘relevant’ minor or more commonly, a ‘bereaved’ minor.
Since 2004, a special tax regime has been in place for certain trusts with vulnerable beneficiaries. The basic rule is that only the vulnerable person can benefit under the trust, but in saying that there is very limited scope for others to benefit – the annual limit being the lower of £3,000 or 3% of the trust fund.
Is this special tax treatment automatic?
Trustees must claim it (for a particular tax year), but can only do so if these three conditions are satisfied.
- There is a beneficiary who falls within the definition of a vulnerable person (see 1. above).
- There is a ‘qualifying trust’ for that beneficiary (see 3. And 4. below), and
- A vulnerable person election has been made for all or part of that tax year.
The claim process requires a vulnerable person election to be made on VPE1 . The form must be signed by the trustees and the vulnerable person. Where the beneficiary is unable to make a legally valid election, it should be made on his or her behalf by someone who is legally entitled to do so i.e. parent, guardian or a person having the relevant powers of attorney.
The election has a time limit and requires the effective date to be specified. If for example the effective date was 31 December 2020 (tax year 2020/21) then an election must be made by 31 January 2023. The election is irrevocable until the person ceases to be vulnerable, the trust ceases to be qualifying, or the trust terminates. In those circumstances, the trustees must inform HMRC.
What is a qualifying trust for a disabled person?
Two conditions must be met during the lifetime of the disabled person or until the termination of the trust, if earlier.
The conditions are that:
- The property can be applied for the benefit of the disabled person, and
- Either the disabled person is entitled to all the income arising, or, if not entitled to all of it, none of the income can be applied for the benefit of anyone else.
If there is more than one beneficiary, property held for the benefit of a disabled person must be ring fenced i.e. held in a separate fund or in some other defined part of the trust. A ring-fenced fund for a disabled person within a trust is not a separate trust for tax purposes.
How does a trust for a relevant minor arise?
It typically arises through the will of a deceased parent or a statutory trust on intestacy in England and Wales. Where a parent dies without making a will, some or all of the property is held on ‘statutory trusts’ for any children under the age of 18. In England and Wales, the statutory trust is such that the child will, on reaching 18, become absolutely entitled.
The intestacy rules currently in force in Northern Ireland and Scotland are different, and where trusts are established for children who have lost a parent, the terms of those trusts will be such that they will be treated as bare trusts for tax purposes. That means income and gains are taxed automatically on the child and so there is no need for the special tax treatment outlined in 5. below.
A will trust in any part of the UK may however qualify for special tax treatment. Consider for example a wording in the will of a parent stating that funds are left to
“such of my children as survive me and attain the age of 18”.
That wording does not give rise to a bare trust since the children do not take an immediate ‘vested’ interest at death of the testator, but instead they only become entitled if they attain the age of 18. While the child is under 18, the trust will be taxed as a discretionary trust rather than a bare trust, and so qualifies for special tax treatment.
For the avoidance of doubt, any funds left to grandchildren or nieces and nephews will not create a bereaved minor trust. Instead, either a bare trust or discretionary type trust will arise, depending on the wording in the will.
Trusts for vulnerable beneficiaries can qualify for special Income Tax and Capital Gains Tax (CGT) treatment. Why is that needed?
The broad aim is simply to provide relief from the potentially high trustee tax rates. In 2020/21 the trustee rates are as follows.
|Standard Rate on first £1,000 of income||20%|
|Dividend Trust Rate||38.1%|
|Capital Gains Tax Main Rate||20%|
|Capital Gains Tax residential property (not eligible for Private Residence Relief||28%|
These rates are applicable where trustees have the power to accumulate income i.e. a discretionary type trust.
Remember also that trustees have a maximum annual exempt amount of just £6,150.
Does the special tax treatment only apply to the trustees of a discretionary trust? Most commonly it applies to trustees of a discretionary trust, but not always.
For example, a disabled person could have an Interest in Possession (IIP) and enjoy an immediate right to receive any income arising. In that event, the trustee rates are as follows.
The person entitled to the income is personally liable to tax on it and is entitled to a tax credit for the tax paid (or effectively paid) by the trustees.
If therefore the beneficiary is at least a basic rate taxpayer, then a claim for special tax treatment is ineffective for Income Tax but may bring benefits CGT benefits.
How does this special tax treatment work?
The trustees remain responsible for paying trustee Income Tax but may claim a deduction of Income Tax as follows.
- Calculate the trustees’ Income Tax liability assuming no special treatment.
- Calculate how much Income Tax the vulnerable person would have paid if the trust income had been paid directly to them as an individual.
- Trustees can then claim the difference between these two amounts as a deduction from their own Income Tax liability.
The trustees remain responsible for paying trustee CGT due but may claim a deduction of CGT as follows.
- Calculate the Trustees’ CGT liability assuming no special treatment.
- Calculate how much CGT the vulnerable person would have paid if the gains had come directly to them.
- Trustees can then claim the difference between these two amounts as a deduction from their own CGT liability.
This special Capital Gains Tax treatment does not apply in the tax year when the beneficiary dies. It can apply in respect of income tax for that year but the election is in force only until the date of death.
Are there situations where the special treatment does not apply to a trust for a vulnerable person?
In certain situations, anti-avoidance rules deem trust income to be the settlor’s income. These rules apply where the settlor retains an ‘interest’ in the trust fund, and if so, trust income is taxed on the settlor and no one else.
Tax law tells us that a settlor has an interest in the trust fund if there are any circumstances where property will or may benefit the settlor or the settlor’s spouse or civil partner.
Consider therefore a disabled person setting up a trust where he/she can benefit. In that event, the special tax treatment cannot apply for income tax purposes because the settlor is taxed on the income and not the trustees.
There are no such rules for CGT but Instead trustees remain liable for gains in excess of the trustees’ CGT exemption.
In summary, where the settlor does retain an interest then special tax treatment can apply for CGT purposes but not income tax purposes.
What is an 18-to-25 trust?
We need to firstly understand that a trust for a bereaved minor as outlined above has its own IHT rules.
Regardless of the size of the bereaved minor trust fund, there is no IHT charge when the child becomes absolutely entitled to capital or dies before becoming entitled to it. There are no 10 year anniversary charges or exit charges when capital leaves the trust. However, the creation of the trust by the deceased carries no IHT advantages and instead it will just be a chargeable death transfer.
A parent, in their will, can however set up an 18-to-25 trust to delay the age the child inherits to age 25, or earlier. The tax treatment for income tax and CGT are the same as for Bereaved Minor Trusts.
With regard to IHT, again the 10-yearly charges don’t apply. However, the main differences are
- The child must become fully entitled to the assets in the trust by the age of 25
- When the beneficiary is aged between 18 and 25, IHT exit charges may apply but only if the trust fund exceeds the Nil Rate Band available to the trustees
The exit charge will be a fraction of 6%, with the amount depending on how long after the age of 18 the payment is made. For example, if the child inherits at age 21 the inheritance tax rate will be 3/10hs of 6% = 1.8%. If the child inherits at age 25 the maximum IHT rate will be 7/10ths of 6% = 4.2%.
In summary the IHT exit rates are low or nil for smaller trust funds. That may be appealing to those wishing additional control over young beneficiaries becoming entitled to large sums of money.
Are there any IHT benefits applicable to trusts for disabled persons?
A family member may wish to set aside funds in trust for a disabled person. Or perhaps the trust might be set up by the disabled individual personally.
The two main options are a Discretionary Trust and a Disabled Person’s Trust.
A discretionary trust gives the trustees complete flexibility in deciding how to use income and capital, and where the funds are modest then a straightforward discretionary trust might fit the bill. But for larger amounts, the tax charges relating to discretionary trusts need carefully considered. IHT is a big problem where large sums are involved which is why a Disabled Person’s Trust might be set up to conform with S89 IHTA 1984. The IHT situation is then as follows.
- If you set up a disabled trust for someone else, then that qualifies as a 7 year PET.
- If the disabled person sets it up personally because they have a condition that’s expected to make them disabled, that’s not chargeable to IHT because the property remains in their estate.
- Although 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 disabled person dies or if the trust comes to an end during their lifetime.
Personal Injury Trusts
The term the term “Personal Injury Trust” has no statutory basis. Instead, it’s simply the name given to trusts which are usually set up by solicitors to receive payments arising as a result of an accident, injury or malpractice.
There is no requirement for the beneficiary to be classified as disabled and therefore it’s different to those disabled trusts considered above.
A Personal Injury Trust will either be set up by the injured person themselves, or set up by the Court or a parent on behalf of a child using the child’s funds with Court Authority. The injured person is the settlor and can also be a trustee but where the funds are significant then a professional trustee might be appointed.
There are different reasons to set up a Personal Injury Trust. The injured person may not feel able to manage large funds of money on their own. Also, funds outside of a trust may be taken into account for the purposes of means assessment.
The first payment received following a personal injury is disregarded for 52 weeks when assessing entitlement to means tested benefits and services. This disregard doesn’t apply to any later payments. After 52 weeks, it is then taken into consideration for means tested benefit, assessment, purposes. The 52 week rule is a temporary period of grace, not a time limit as such and so a Personal Injury Trust can even be set up after this time period has elapsed. If it is set up after 52 weeks, the client’s income and capital for the period from the 52 week point until the trust is set up will be taken into account when the individual is being assessed for means-tested benefits.
If at all possible, the trust should be set up before the individual receives the funds otherwise the funds will be treated as belonging to the individual before the trust was established.
Personal injury trusts are nearly always bare trusts, and as a result there is usually very little tax consequence in setting one up. The other standard option is a discretionary trust. Clearly specialist advice is needed if a discretionary trust is being set up since the tax treatment is complex and can be made more tricky where the injured party is both settlor and beneficiary.
A Personal Injury Trust might qualify as a trust for vulnerable or disabled beneficiaries but that depends on the circumstances.
There will be many reading this against the backdrop of advising on a potential trustee investment case. If so, regardless of type of trust, the trustees will almost certainly have wide investment powers either through the specific wording in the trust deed, statutory powers or a combination of both.
Where a bereaved minor is benefitting under intestacy laws in England & Wales, or there is a will where the child’s entitlement is delayed to a specific age (18 for example) then the Income Tax & CGT rules of discretionary trusts apply (before the child becomes entitled) unless a Vulnerable Person’s Election is made where the trustees are only paying tax in line with what the liability would have been had the income & gains arisen directly to that person. In saying that, a Vulnerable Person’s Election is not always necessary. If for example the trustees purchased a non-income producing Offshore Insurance Bond, then until the beneficiary becomes absolutely entitled, the trustees would be liable, but only if a chargeable event gain occurred. If therefore the trustees could confine withdrawals to within 5% limits then no trustee tax would arise and when the child reached the appropriate age, he/she would inherit the withdrawal history of the bond and become taxable on future gains. There are no doubt many case where a child is benefitting after someone’s death and those funds remain intact until the child becomes entitled.
Where you have a bare trust for a minor – either arising under the terms of the will or it’s a statutory trust on intestacy in Scotland or Northern Ireland, then the child is simply taxed and not the trustees. From a tax perspective, that’s welcome as children have the same allowances, reliefs and exemptions. as adults. Offshore Bonds and OEICs spring to mind as investments that can mop up the Personal Allowance, the 0% Starting Rate for savings, the Personal Savings’ Allowance’, the Dividend ‘Allowance’ and the annual CGT exemption
Where you encounter a Personal Injury Trust, it’s likely to be a bare trust so that the ‘injured’ beneficiary is taxed and not the trustees. Again, from a tax perspective, this may be an exercise in Blending OEICs and Bonds.
And finally, where you have a qualifying trust for a disabled person then remember that the income tax & CGT rules of discretionary trusts apply unless a Vulnerable Person’s Election is made whereby the trustees are only paying tax in line with what the liability would have been had the income & gains arisen directly to that person.
There are undoubtedly complexities with trusts for care and compensation but understanding those complexities can reap rewards.
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