Trusts are a very useful and often vital mechanism for vulnerable individuals because it allows funds to be held by persons (known as the 'trustees') for the benefit of the vulnerable individual. The vulnerable individual does not need to be involved with the management of the funds themselves, if this is not considered suitable or they are not able to. The main protection provided by a trust is that the vulnerable individual does not have sole control of the assets in the trust.
Vulnerability takes many forms: addiction, poor financial management, relationship difficulties, bereavement, physical disabilities, and mental health issues. There is no one-size-fits-all trust for a vulnerable individual; that person's needs and circumstances will dictate what type of trust is chosen, and professional advice is vital to getting that decision right.
Available trust structures
There are three main types of trusts which might be relevant for vulnerable individuals, being life interest trusts, discretionary trusts and vulnerable beneficiary trusts.
Life Interest Trusts
Life interest trusts are those where a certain beneficiary (known as the 'life tenant') is entitled to all income which arises from the trust. These are least likely to be appropriate for vulnerable individuals because all the income generated by the trust must be paid to the vulnerable individual and therefore might affect the vulnerable individual's entitlement to means tested benefits. If the vulnerable individual is not entitled to means tested benefits thought still needs to be given to the amount of income that the capital of the trust will create and whether this is appropriate for the vulnerable individual to receive.
In some circumstances, however, a trust where the vulnerable individual has a clear right to something, which the trustees cannot take away from them, may have its advantages.
Discretionary Trusts
Discretionary trusts give the trustees full discretion over how the capital and income within the trust can be used for the benefit of the chosen class of beneficiaries. As a result, the assets within the trust do not aggregate with the vulnerable individual's assets for the purposes of means tested benefits. This means the trustees can exercise their discretion to transfer capital and/or income to the vulnerable individual as and when it is appropriate to do so in a way that doesn't affect their means tested benefits.
Vulnerable Beneficiary Trusts ('VBTs')
Unlike life interest trusts and discretionary trusts, which can be created even if there are no vulnerable individuals involved, a VBT has several strict requirements one of which is that there must be a "disabled beneficiary", who is a person who by reason of mental disorder as defined under the Mental Health Act 1983 is incapable of administering their property or managing their affairs, or a person who is in receipt of the specific social security benefits set out below relating to disability:
- Attendance allowance
- Disability living allowance for adults or children (but the person must be entitled to the care component at the highest or middle rate or the mobility component at the higher rate)
- Personal independence payment
- Increased disablement pension
- Child Disability Payment
- Adult Disability Payment
- Industrial Injuries Disablement Benefit
- Constant attendance allowance
- Armed forces independence payment.
In addition to the beneficiary meeting the criteria above, the trust itself must be a "qualifying trust". This means that during the disabled beneficiary's lifetime any capital leaving the trust must be used for the benefit of the disabled person and the disabled person must either be entitled to the trust income, or, if the trustees have discretion as to if and when the income is paid out, then any income payments must be for the benefit of the disabled person during their lifetime.
Other people can be named as potential beneficiaries, but the trustees are limited to how much the other beneficiaries can receive, currently being the lower of £3,000 per tax year or 3% of the maximum value of the trust fund.
Inheritance tax ('IHT') treatment of different trusts
Whilst there can be income tax advantages for VBTs, these potential advantages are not covered further in this insight, but advice can be provided separately if required.
In terms of IHT, most trusts created during the lifetime of the person putting the money into the trust (known as the Settlor) are liable to pay IHT on creation of the trust up to 20%, and then every ten years (of up to 6%) during its existence and whenever assets leave the trust.
For discretionary trusts and life interest trusts (which are not VBTs) the assets in the trust are not aggregated with the disabled beneficiary's own estate for IHT purposes when the disabled beneficiary dies.
Whilst VBTs are not subject to IHT charges on the creation of the trust, during the life of the Settlor or during its existence, the downside is that the value of the assets left in the trust will aggregate with the disabled person's own assets for IHT purposes on their death.
Worked Example – IHT Treatment
In this worked example a parent settles £3million on trust to look after their disabled child from which the trustees buy a property for the disabled beneficiary to live and the disabled beneficiary also receives income (but not capital) from the trust. After 10 years the trust assets are valued at £4M, and after 20 years they are valued at £5M. The disabled beneficiary dies just over 20 years after the creation of the trust. After the disabled beneficiary's death, the trust assets are used for the benefit of the disabled beneficiary's siblings (i.e. do not pass to charity).
Life Interest trust (not created on death) and Discretionary Trusts
Assuming the parent had made no other gifts, they could apply their nil rate band against the trust, but thereafter IHT would be charged at 20% on creation as per the below:
- (£3M - £325K) x 20% = £535,000 of IHT payable on creation.
On the first 10-year anniversary of the trust the IHT payable would be approximately as follows:
- (£4M - £325,000) x 6% = £220,500
On the second 10-year anniversary of the trust the IHT payable would be approximately as follow
- (£5M – £325,000) x 6% = £280,500
Vulnerable beneficiary trust
In this example, there would be no IHT payable until the disabled beneficiary dies. However, when they die the value of the trust assets are aggregated with the disabled beneficiary's estate and the IHT payable by the trustees of the VBT at that time would be approximately as per the below:
- (£5M - £325K) x 40% = £1,870,000 of IHT payable on the disabled beneficiary's death.
Whilst this highlights the overall long-term tax efficiency of a discretionary trust rather than a VBT, often tax efficiency is not the driving force in why these trusts are created. An awareness of the tax is very important but is unlikely to be the primary factor in deciding on the type of trust.
Indeed, for some people, deferring IHT to the end of the life of the trust and therefore maintaining the largest fund possible for the lifetime of the vulnerable individual to be able to best support them is the priority.
Conclusion
Whilst trust structures are a very useful mechanism for vulnerable individuals, the correct form of trust structure needs to be carefully thought through and is dependent on a range of factors such as the nature of the vulnerability of the primary beneficiary and the settlor's family circumstances.
It may be that using a combination of more than one trust structure is the best approach and that the type of trust used for planning during the lifetime of the Settlor may be different to the type of trust set up in the will of the Settlor to take effect on their death.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
