A very real concern of parents or guardians who have an adult child with disabilities is how to provide for them financially once they themselves have died.
The law surrounding this area can be a bit of a minefield and this article aims to clarify some of the confusion.
Generally speaking, when providing financial support for someone who is unable to deal with their finances themselves, one of the best mechanisms to use is a Trust.
Contrary to popular belief, a trust’s primary purpose is not mitigating tax, but it is first and foremost a way of separating ownership into two types of ownership – the legal ownership and the beneficial ownership. As such, the protective nature of a trust is particularly useful when you wish to provide for someone with disabilities.
The legal owners are the trustees – who would hold the assets (e.g. land, bank accounts) in their names.
The beneficial owners are the beneficiaries – who have the right to the financial benefit – be it capital or income – from those assets.
The sorts of trusts to consider are:-
- Discretionary Trust
- Disabled Trust
- Protective Trust
- A trust run by a specialist Charity, e.g. Mencap Trust Company
Considerations when making plans
Before deciding which sort of trust is most suitable for your circumstances, a number of considerations will need to be balanced and taken into account.
The sorts of things to consider are:-
- The nature of the person’s disability.
- The means-tested and other state benefits which that person is receiving.
- The financial position of the parents or guardians or attorneys and whether they are able to ring-fence funds immediately or only on death
- Other friends / family members / carers / professionals who are prepared to take responsibility upon the death of the parents / guardians.
- Charities that may be able to provide assistance in relation to that specific disability.
Once all of these considerations have been taken into account, it is possible to make suitable arrangements depending on everyone’s needs.
The nature of the person’s disability
Does the person with a disability have a physical or a mental disorder?
If they have a physical disorder and are adults, they are able to deal with their finances themselves. However, they may not wish to, in which case, they might wish to enter into one or two Lasting Powers of Attorney – one for Finances and one for Health & Welfare.
If they have a mental disorder, then this is when a trust is appropriate.
What state benefits is that person receiving? And are they means tested?
To name just a few, a non-exhaustive list of examples to consider:-
- There are some that are not means tested – such as Personal Independence Payment (PIP) or Severe Disablement Allowance or the State Pension.
- There are some that are not means tested but the level of payment is dependent on the care needs – such as Disability Living Allowance and Carer’s Allowance and Attendance Allowance.
- There are some that are means tested – such as Employment & Support Allowance or Statutory Sick Pay or Incapacity Benefit.
The sort of benefits currently being received will have a bearing on the type of trust you are most likely to choose.
Most people wish to preserve the benefits being received as far as possible, so you need to look closely in particular at those benefits which are means tested.
The financial position of the parents / guardians
Are you in a financial position to ring-fence some funds immediately or only upon your death through your Will?
Both routes are possible, but your adviser needs to know which you would prefer or are in a position to do.
People to take responsibility
One of the most important decisions you will make is who should act as trustees of the trust. They should be people you trust to make financial decisions on behalf of the person with disabilities.
They will have to act unanimously and will become the legal owners of all the assets you put into the trust and will be guided by the trust documents to distribute those assets in accordance with your wishes.
Some people choose family members, others choose professionals, but many choose a mixture of the two – some who know the family situation, and others who know the law. The initial choice of trustees rests with the person setting up the trust.
Most people choose between 2 and 4 trustees to run their trust.
It is worth noting that some charities are able to provide assistance in relation to the specific disability you are dealing with.
One such charity is Mencap. In fact, they have a Trust Company who are able to act as trustees for beneficiaries with learning difficulties.
This can be particularly useful if you do not have anyone to ask to act as trustee and your estate is modest.
The taxation of the trust will depend upon the type of trust you set up and whether you set it up in your lifetime or through your Will.
A discretionary trust is one where the trustees have discretion as to who (amongst a class of beneficiaries) to pay the funds out to. This means that the beneficiaries have a mere ‘hope’ of receiving funds from the trust, rather than an absolute right to funds.
This is particularly useful if you do not wish the trust fund to adversely affect means tested benefits. Means tested benefits are not affected by such a trust.
On creation of such a trust in your lifetime, if the value of the gift is over an above the Nil Rate Band, then the donor of the gift would need to pay a 20% inheritance tax charge on the value over and above the Nil Rate Band. The Nil Rate Band is currently £325,000.
Within the trust, higher rates of income and capital gains tax are payable by such a trust, although the correct choice of investment can mitigate the effects of this this.
A discretionary beneficiary is only liable to income tax on distributions he or she actually receives and at the rate that beneficiary would ordinarily pay.
In terms of Inheritance Tax, a periodic charge arises on the ten year anniversary of the creation of the Discretionary Trust. The maximum charge on any one ten year anniversary is 6% of the value of the Trust Fund. In addition, an exit charge arises when property or assets are distributed to a beneficiary. This charge is based on the time the property has been in the trust since a periodic charge last arose.
If you create such a trust on your death through your Will, after the deduction of any available Nil Rate Bands (i.e. the initial nil rate band, any transferable or residence nil rate band and any other reliefs available on death), your estate will be taxed at a rate of 40% and then the amount you have specified in your Will will pass into the discretionary trust.
During the lifetime of the trust, it is taxed as above for income, capital gains tax and inheritance tax purposes.
There are two types of disabled trust for tax purposes – qualifying and non-qualifying.
A non-qualifying disabled trust would be taxed as a discretionary trust.
A qualifying disabled trust attracts tax reliefs but the categories of disability are limited to:-
- Incapable by reason of mental disorder within the meaning of the Mental Health Act 1983 of administering his property or managing his affairs or
- In receipt of Attendance Allowance or
- In receipt of Disability Living Allowance by virtue of entitlement to the care component at the middle or highest rate.
For this purpose (and also for tax purposes), a ‘mental disorder’ is defined as a ‘mental illness, arrested or incomplete development of mind, psychopathic disorder and any other disorder or disability of mind’.
Four categories of mental disorder are specified as follows:-
- a) Mental illness – not defined.
- b) ‘Severe mental impairment’ – ‘a state of arrested or incomplete development of mind, which includes severe impairment of intelligence and social functioning and is associated with abnormally aggressive or seriously irresponsible conduct on the part of the person concerned’.
- c) ‘Mental impairment’ – defined in the same way as severe mental impairment except that the phrase ‘severe impairment’ is replaced by ‘significant impairment’.
- d) ‘Psychopathic disorder’ – ‘a persistent disorder or disability of mind (whether or not including a significant impairment of intelligence) that results in abnormally aggressive of seriously irresponsible conduct on the part of the person concerned’.
If the conditions are satisfied, the disabled trust is a ‘qualifying disabled trust’.
However, payments received out of a disabled trust could potentially affect means tested benefits, and if that person’s income is high enough, they may need to pay income tax on this income when received in their hands.
Capital gains tax is also payable by the trust in the event of any sale of assets which may produce a gain.
However, if further funds are put into the trust fund, no further claims for tax arise at that point.
If funds are distributed out of the trust fund, there is no rise to Inheritance Tax, no 10-yearly charge and no exit charge.
When the disabled person dies, the trust ends and is treated as an asset in the disabled person’s estate. This means it will be subject to Inheritance Tax at 40% if the disabled person’s Nil Rate Band is exceeded. Only then can assets in the trust go to the other named beneficiaries who are entitled upon the death of the disabled person.
Although the disabled trust may be favourable for some tax purposes, it may however adversely affect the benefits the disabled person receives if he or she receives income in his or her hands.
A Protective Trust
A protective trust is a trust which is a life interest trust (i.e. income passing to the chosen beneficiary) until such time as a triggering event occurs (e.g. death, bankruptcy or divorce), whereupon it is regarded as a discretionary trust.
It is therefore taxed as a life interest trust (just like the interest in possession above) up till the point of the triggering event at which point it is taxed as a discretionary trust.
A Life Interest Trust is subject to income tax and capital gains tax within the trust and the beneficiary is taxed on any income received in his / her hands.
A Mencap trust
Under this option, you would set up a trust with Mencap and then make gifts to it through your Will.
It would be taxed as a discretionary trust.
The Mencap Trust Company Limited would be the trustees of this trust and may not produce the largest tax saving available to you if you are concerned about reducing your estate in your lifetime.
This option is often suitable for families where you have no obvious person to appoint as trustees, where upon the death of the disabled person, you are happy to leave your estate to Mencap, and where you are not concerned about reducing the inheritance tax bill.
This article is generic and if you would like specific advice or would like to discuss the issues in this article further, please do not hesitate to contact Helen Freely, a partner in our Private Client Department on 0207 638 9271.