Securing the future

Where a person wishes to provide for someone with a learning disability after they die, they are likely to have a number of concerns.

How will the beneficiary cope with the inheritance? Will they be able to manage the capital? Might they be taken advantage of? Are they even capable of receiving the money – that is, do they have the capacity to give valid receipt to the executor?

What impact will the bequest have on the beneficiary’s entitlement to means-tested benefits and to local authority (LA) support?

And if a parent were to put in place a structure to address the points above, how complex and expensive would it be to administer and what are the tax implications?

Faced with these concerns, parents have three main options for providing for a disabled child (advising parents is the most common scenario, but the same principles apply to anyone leaving a gift to a person with a disability).

The first is to leave an outright bequest to the person with a disability. However, this is rarely advisable because it will usually have an impact on the beneficiary’s access to means-tested benefits and community care, and the beneficiary may have difficulty managing the inheritance and be susceptible to people taking advantage of them.

The second is to exclude the disabled son or daughter from the will or give them only a token bequest, leaving the estate to other siblings with an accompanying letter explaining their wish that the other children each use half of their share to support their sibling. While this approach avoids the problem of an outright gift as outlined above, it is still rarely advisable because there is no guarantee that the money will be used to benefit the disabled person. This option also leaves the estate open to a claim for reasonable provision under the Inheritance (Provision for Family and Dependents) Act 1975.

The third is to leave a share (or the entirety) of the estate on trust, either created by will or during the settlor’s lifetime. There are various types of trust, each with different implications for tax and means-tested benefits / community support, and in advising a client, both tax and benefits need to be given consideration in relation to the client’s particular priorities and concerns, as well as family and financial circumstances.

In this article, I focus on the third of these options outlined above, with a particular emphasis on discretionary trusts, how they operate, and their implications for means-tested benefits.

What is the definition of disability?

The law defines disability in a number of ways, depending on the context. For trusts and tax purposes, the definition is in section 89(4) of the Inheritance Tax Act 1984 (ITA 1984), which defines a disabled person as a person who is:

“(a) incapable, by reason of mental disorder within the meaning of the Mental Health Act 1983 of administering his property or managing his affairs, or

(b) in receipt of attendance allowance under either the Social Security Benefits Act 1992 section 64 or the Social Security and Benefits (Northern Ireland) Act 1992 section 64; or

(c) In receipt of disability living allowance [(DLA)] under section 71 of the [two acts mentioned in paragraph (b)] by virtue of entitlement to the care component at the highest or middle rate.”

Under this definition, a person also qualifies (under sections 89(5)-(6)) as disabled if they are eligible for attendance allowance or DLA, but are not receiving it for specified reasons, such as living in a care home or being in hospital for renal dialysis.

Most people meet this definition of disabled by virtue of the third category – receipt of the care component at the highest or middle rate of DLA. The DLA care component at the highest or middle rate is paid to people whose disability is such that they need frequent support / attendance for bodily functions or continual supervision to avoid substantial danger to themselves or others (under sections 64 and 72 of the Social Security and Benefits Act 1992).

DLA has been used as a way of defining vulnerable beneficiaries for over 35 years – it was introduced in 1992, but it mirrors a similar benefit (part of Attendance Allowance) that was introduced in 1977. However, it is now being phased out and replaced by Personal Independence Payments (PIPs). It therefore became necessary to introduce a new definition of disabled, in the Finance Act 2013 (FA 2013).

The new definition of a disabled person is contained in schedule 1A(1) to the Finance Act 2005, as follows:

“‘Disabled person’ means:

(a) a person who by reason of mental disorder within the meaning of the Mental Health Act 1983 is incapable of administering his or her property or managing his or her affairs;

(b) a person in receipt of attendance allowance;

(c) a person in receipt of a disability living allowance by virtue of entitlement to the care component at the highest or middle rate;

(d) a person in receipt of personal independence payment by virtue of entitlement to the daily living component;

(e) a person in receipt of constant attendance allowance[, or,

(f) a person in receipt of armed forces independence payment]”.

How does a disabled / vulnerable person trust work?

The key requirements for disabled / vulnerable person trusts are set out in section 89 of the ITA 1984.

Section 89, as amended by the FA 2013, states:

“(1) This section applies to settled property transferred into settlement after 9 March 1981 and held on trusts –

(a) under which, during the life of a disabled person, no interest in possession in the settled property subsists, and

(b) which secure that, if any of the settled property or income arising from it is applied during the disabled person’s life for the benefit of a beneficiary, it is applied for the benefit of the disabled person.

(2) For the purposes of this act the person mentioned in subsection (1) above shall be treated as beneficially entitled to an interest in possession in the settled property.”

This legislation enables a parent to set up a trust that is essentially discretionary (the disabled person does not have an “interest in possession”) but which is taxed in a very different way to traditional discretionary trusts.

Leaving an outright bequest to a person with a disability is rarely advisable because it will usually have an impact on the beneficiary’s access to means-tested benefits

Tax benefits

There are a range of inheritance tax (IHT), income tax and capital gains tax (CGT) advantages that apply to trusts that fall within this category. To obtain these advantages, the trust must be drafted to restrict the way the income and capital in the trust is used. The law concerning the nature of these restrictions was changed by the FA 2013, with effect from 8 April 2013. There is transitional relief for trusts set up before this date that cease to qualify.

Before 8 April 2013, there were different rules relating to different areas of tax, so to benefit from all of the tax advantages available, it was necessary to draft a trust that complied with a number of different legislative provisions that did not sit comfortably together.

Since 8 April 2013, the various restrictions on the use of capital and income in the trust have been harmonised, so that the same rules apply to IHT, income tax and CGT. The new rule is simply that, during the life of the vulnerable beneficiary, if any capital and / or income is applied, it is applied for the benefit of the disabled beneficiary only.

The one proviso to this is that the legislation permits trustees to apply for small amounts of income and capital (up to a maximum of £3,000 or 3% of the trust fund annually) without it having to be for the benefit of the vulnerable beneficiary.

Grandfathering provisions were included in the FA 2013, so that funds added after 8 April 2013 to pre-existing trusts that were compliant with the old legislation will be subject to the old rules.

It should also be noted that, as previously, it is not necessary to exclude the statutory power of advancement under section 32 of the Trustee Act 1925 for a trust to be compliant with the legislation.

The tax benefits of drafting a trust that complies with the above-described rules are as follows.

For IHT, a transfer into the trust is a potentially exempt transfer rather than a chargeable transfer, and therefore, so long as the settlor lives seven years, there will be no charge to IHT on lifetime gifts to the trust. There are no 10-year anniversary charges or exit charges on capital. The trust property is deemed to belong to the disabled person’s estate and is aggregated with his or her estate on death. It should be noted that because the disabled person does not actually have an interest in possession and is not deemed to have one for CGT purposes, there is no tax-free uplift on death.

In order to benefit from the income tax and CGT advantages, the trustees must make a ‘vulnerable person election’. Once this election has been made, the income tax on the trust income and any CGT on capital gains made on funds in the trust will effectively be reduced to the amount that the disabled / vulnerable beneficiary would have paid themselves. This is a significant difference to the amount of tax payable in a ‘normal’ discretionary trust (see below). In addition, the trust will be entitled to twice the normal capital gains-exempt amount for trustees (that is, the trustees can benefit from the full exemption for an individual, rather than the reduced amount available for trusts).

How does a discretionary trust work?

A discretionary trust is a trust where trustees have a discretion as to whether or not to make payments to any of the beneficiaries, and cannot be compelled to make any such payment. In other words, the beneficiaries do not have a right to require the trustees to exercise the wide discretion that they have in their favour. Typically, a settlor will choose a class of beneficiaries of which the disabled beneficiary would form a part (for example, children and grandchildren of the settlor), and set out his or her wishes in a non-binding letter of wishes.

Discretionary trusts are taxed under the relevant property regime. This means that lifetime transfers are not potentially exempt transfers, but chargeable transfers. IHT will be payable at 20% once the nil-rate band (£325,000) is exceeded.

In addition, an IHT charge is payable every 10 years and when assets leave the trust (exit or proportionate charges). Income tax is charged at the special trust rate (45%) and CGT at the higher rate (28%). There is a reduced annual exempt amount (half that available to individuals).

Eligibility for benefits?

When assessing a disabled person’s eligibility for means-tested benefits or local authority / community support, a discretionary trust of which they are a beneficiary will not be taken into account. Discretionary, for these purposes, means that the trustees have a discretion to make, or not to make, payments to the disabled person, and cannot be required to make any payments to them.

Income support and housing benefit

Entitlement is lost where a person has capital exceeding £16,000. If a person has between £6,000 and £16,000, the benefit will be reduced by £1 for every £250 the person has over £6,000, up to the maximum £16,000.

There are detailed rules (under regulation 52(2) of the Income Support (General) Regulations 1987 (SI !987/1967) and regulation 49(2) of the Housing Benefit Regulations 2006 (SI 2006/213)) specifying what counts as capital for the purpose of assessing eligibility, and these provide that a discretionary trust will not be taken into account, as does the Department of Works and Pensions Decision Makers Guide (volume 5, chapter 29, 29238-28513).

Residential accommodation provided by the LA

Many people with learning disabilities are dependent on LA funding for their accommodation, and for many parents, it is the future of this provision that is of the greatest concern.

If a person has over £23,250 of capital, they will not be entitled to receive financial assistance from the LA for their residential care. If a person has between £14,250 and £23,250, the benefit will be reduced by £1 for every £250 between £14,250 and £23,250. With regard to income, residents are entitled to personal expenses allowance, which is currently £23 a week. Income above this will be taken into account.

The method for calculating capital and income is set out in the Department of Health’s Charging for Residential Care Guidelines (CRAG). Chapter 10 of CRAG specifically addresses capital and income in trusts and makes clear that discretionary trusts should be excluded from the calculation. (See also paragraphs 6.059 (concerning treatment of capital) and 8.042, 8.066, and 8.072 (concerning treatment of income).)

Paragraph 10.021 of CRAG states: “Where payments are made wholly at the discretion of the trustees and there is no absolute entitlement either to capital or income, only take into account payments which are actually made. Do not assume notional capital or income from a discretionary trust”.

LA non-accommodation services

LAs provide a wide range of services, including personal care, transport, day centres, and leisure facilities. Eligibility varies by LA, but normally, similar principles to those found in CRAG are applied, so discretionary trusts will not be included in calculations of eligibility.

Direct payments and independent living

Following an assessment of need, a disabled person (or their carer) can be paid a sum of money in order to pay for their own care needs by way of a direct payment. The regulations in relation to this are set out in the Community Care, Services for Carers and Children’s Services (Direct Payments) Regulations 2009 (SI 2009/1887). Practice guidance is set out in the Department of Health’s Guidance on direct payments for community care, services for carers and children’s services in England (2009).

A person in receipt of direct payments will be expected to make a financial contribution that is reasonably practicable for them to pay. In assessing what is a reasonable amount to pay, LAs are guided to take into account similar considerations to those in CRAG, and so discretionary trusts should not be taken into account in the assessment (paragraph 87 of Fairer Charging Policies for Home Care and other non-residential Social Services).

Where a beneficiary has a right to income or capital

Where a beneficiary has an absolute entitlement to income or capital, this will be taken into account when assessing eligibility for means-tested benefits and community care. This applies to all of the benefits and community services set out above.

With regard to capital, if a person is not in possession of capital to which they have absolute entitlement, but the capital would become available to them upon application being made, they are treated as possessing that capital as an actual capital asset.

With regard to income, where a person has absolute entitlement to income from a trust, the income they receive is taken into account. If the disabled person does not receive the income to which they have an absolute entitlement, but the income would become available to them upon an application being made, in assessing eligibility

for benefits they are treated as possessing that income as an actual income.

The future of discretionary trusts

The logic behind not taking discretionary trusts into account in assessing eligibility is clear. Since a beneficiary of a discretionary trust has no right to the income or capital of the trust, and the trustees are entitled to not distribute anything to the beneficiary, it is difficult to see how the contents of a trust could be considered theirs. However, there is nothing sacrosanct or inviolable about a discretionary trust, and parents need to be advised that, while the capital and income of a discretionary trust might today not be taken into account in assessing eligibility for benefits or services, there is no certainty about the future.

In the past, discretionary trusts have been taken into account when assessing a person’s eligibility for benefits. Under the Supplementary Benefit Rules (which were replaced by income support), a beneficiary was treated as having both an income and capital entitlement if there was a “real probability” that the trust fund would be used for them.

Moreover, there have been a number of cases concerning attribution of assets under section 25 of the Matrimonial Causes Act 1973, where a discretionary trust has been taken into account (see, for example, Browne v Browne [1989] 1 FLR 291 at pages 291-296 and Charman v Charman [2007] EWCA Civ 503). While this is a very different context, it nonetheless highlights that discretionary trusts can be – and, in some cases, are – attributed to one or more of the beneficiaries.

Should a trust be created in the settlor’s lifetime or by will?

Many clients prefer a lifetime trust, as this creates a mechanism whereby other family members or friends can leave money intended for the disabled person. Where a trust is created during a settlor’s lifetime, typically only a small amount will be settled initially, and the settlor will leave a proportion of their estate to the trust in their will.

Who should be appointed as trustees?

Great care needs to be taken in appointing a trustee. Frequently, a settlor will appoint a son or daughter who does not have a disability as both a trustee and beneficiary. One difficulty this creates is that the trustee will be entitled to use the trust assets for their own benefit, which gives rise to a conflict of interest. One way to mitigate the potential problem is to appoint at least one trustee who is not a beneficiary. This might be a professional, such as a solicitor or accountant.

For a professional trustee where there is a disabled beneficiary, one of the challenges is dealing with a beneficiary who may have a limited understanding of the arrangement and the costs involved. It is not unknown for a beneficiary to telephone a solicitor over and over in relation to matters that are only of limited relevance to the trust. One option for parents to consider is the Mencap Trust Company, which acts as a trustee for learning disabled beneficiaries. One disadvantage of the Mencap Trust is that they will only act as a sole trustee, and this makes it unsuitable for the majority of clients who have other people in mind (usually other children) to serve as trustees.

What kind of trust should be used?

As with much of the advice given to a client, careful consideration will need to be given to both the tax and benefits implications of the trust.

In considering which type of discretionary trust to use, a solicitor should consider a range of factors, including the following.

• Would the settlor prefer the greater flexibility of a standard discretionary trust?
• Does the intended beneficiary meet the required definition for a disabled / vulnerable person trust?
• What is the best option in terms of IHT? A trust meeting the requirements of section 89 of the ITA 1984 has a very different tax treatment from other discretionary trusts. It is particularly helpful for trusts set up during a settlor’s lifetime, where they plan to give more than the IHT nil-rate band. However, in some cases, it may be preferable to be taxed under the relevant property regime – for example, where it would be disadvantageous for the trust to be aggregated with the estate of the deceased person on their death. This requires careful consideration in light of the client’s financial position and the amount of money that is likely to be transferred into the trust.
• What is the best option in terms of means-tested benefits?

Both disabled / vulnerable person trusts and other discretionary trusts, so long as they are genuinely discretionary, should escape inclusion in assessment of eligibility for means-tested benefits. However, as noted above, there is a risk that the law could become less favourable in this regard. An advantage of a ‘normal’ discretionary trust is that the trust can be drafted in a way that does not identify the trust with the disabled person. There can be a class of beneficiaries, including the disabled person, that does not mention them by name. The duration of the trust can be a number of years, rather than linked to the life of the disabled person. It should be borne in mind that the trust may be read by someone in a LA that is not familiar with the legal technicalities, and they may react very differently to a trust that specifies the disabled person as a principal beneficiary to one where the disabled person is not even mentioned – even if both trusts are in fact ‘discretionary’.