Trusts For The Disabled: An Augean Stable?

Richard Oerton

(1993) P.C.B. 161

This article focuses on some of the key factors, especially means-tested public funding, which advisers need to bear in mind in considering the favourable tax treatment currently available in relation to trusts for the disabled, created inter vivos or by will. It should not be mistaken for a comprehensive treatment of the many difficult issues which confront those seeking to make financial provision for the mentally or physically disabled.⁽¹⁾

Inheritance tax

(a) The rules themselves

If property is transferred into settlement on or after March 10, 1981,⁽²⁾

favourable inheritance tax treatment is available under section 89 of the Inheritance Tax Act 1984. This applies to trusts

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

which secure that not less than half of the settled property which is applied during his life is applied for his benefit."

A disabled person is defined for this purpose by subsection (4) as a person who, "when the property was transferred into settlement" (italics supplied) was

"(a) incapable, by reason of mental disorder within the meaning of the Mental Health Act 1983,⁽³⁾

of administering his property or managing his affairs, or

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

in receipt of a disability living allowance under section 71 of the Social Security Contributions and Benefits Act 1992 or the Social Security Contributions and Benefits (Northern Ireland) Act 1992 by virtue of entitlement to the care component at the highest or middle rate."⁽⁴⁾

If it were not for the special treatment accorded by section 89, a trust of the kind described above would fall within the relevant property regime and be taxed accordingly. The result produced by section 89(2) and by section 3A(l) and (3), however, is that the disabled person is treated instead as having an interest in possession in the settled property for the purposes of the 1984 Act, so that

a lifetime transfer into such a trust by the disabled person himself is, for those purposes, a non-event (though it would be a capital gains tax occasion with no holdover relief);
a lifetime transfer by anyone else is a potentially exempt transfer rather than a chargeable one (but with the same capital gains tax consequence);
there are no exit charges on capital payments made to or for the benefit of the disabled person⁽⁵⁾ (but those made to or for the benefit of anyone else would be potentially exempt transfers by him); and
there are no ten yearly charges but there is a charge on the death of the disabled person, when the settled property is aggregated with his free estate (and without the benefit of the capital gains tax uplift which is available when a genuine life interest ends on death).

Section 89(3) provides expressly that settled property does not fall outside the requirements summarised above merely because the settlement incorporates the power of advancement given by section 32 of the Trustee Act 1925 (or s.33 of the Trustee Act (Northern Ireland) 1958). This power is commonly varied so as to extend to the whole of a beneficiary's share rather than merely to half. It has been suggested that an extended power would be equally unobjectionable, but this seems by no means clear and it is thought wiser to be content, at least during the disabled person's lifetime, with the statutory power as it stands.

(b) Policy and problems

It would be easier to make sense of the section 89 concessions if one could understand the policy behind them. They seem designed to cater for the case in which the predominant purpose of the trust is to look after the disabled person - the inheritance treatment accorded by the section is (just about) explicable on that basis, and is not explicable as being for the benefit of other beneficiaries under the trust - but in which it is desired at the same time to preserve much of the flexibility normally associated with discretionary trusts.

If this is right, it is a strange paradox indeed that a trust may fall within the section 89 conditions even though the disabled person himself does not, and cannot, receive any benefit under it at all. The requirement that "not less than half of the settled property which is applied during his life is applied for his benefit" is a requirement relating to capital, not to income. (Several writers have asserted that it applies to income, but its wording shows clearly that it does not⁽⁶⁾ and the Revenue is understood to have confirmed this.) And although half of any capital which is applied must be applied in this way, there is no requirement that any capital should actually be applied, or even be capable of application, in any way. So far as income is concerned, section 89 has nothing to say: legally, therefore, there is no need for the disabled person even to be a member of the discretionary class.

Nor, indeed, if one looks at the matter purely from the point of view of taxation, does section 89 produce a particularly desirable result. If the disabled beneficiary is no longer young when the trust is set up, and it is desired that much of the capital shall pass on his death to other beneficiaries, it may be cheaper from the point of view of inheritance tax to create a discretionary trust designed deliberately to fall outside section 89. In other cases there is a great deal to be said for creating a trust under which the disabled person has an actual life interest rather than an interest in possession deemed to exist under the section. In this latter connection the following points may usefully be made:

(1) If the disabled person had the mental capacity to deal with his life interest, any fear that he might do so unwisely could be overcome by making it a protected one.

(2) The inheritance tax consequences of such a trust would ex hypothesi be the same as those produced by section 89 - and a large degree of flexibility could still be attained because income could be made applicable in various ways for the disabled person's benefit and the trustees could have an overriding power of appointment.

(3) Subject only to adding a requirement that at least half the capital applied should be applied for his benefit, the capital gains tax dispensation discussed below could also be obtained.

There would be other advantages as compared with a trust falling within section 89: there would be a capital gains tax uplift on the disabled person's death; capital gains tax would be payable at a flat rate equivalent to the basic rate of income tax, instead of at a rate equivalent to the total of the basic and additional rates; and income would not be taxed initially at the additional rate (as it would be under a section 89 trust) but would belong to the disabled person and be taxed accordingly.

But, of course, as will appear later, it is seldom possible to look at such trusts purely from the point of view of taxation, because means-tested state benefits may come into the picture and a life interest trust would be precluded by a desire to preserve these. At the present day the advantage of bringing a trust within the provisions of section 89 is not that it achieves an inheritance tax result which is not otherwise obtainable, but that it achieves an inheritance tax result which is not otherwise obtainable without loss of means-tested funding. More will be said about this later on.

A final paradox remains to be explored. The result of complying with the conditions in section 89 is that the disabled person is treated as having an interest in possession; yet compliance is impossible if he really does have such an interest. On the face of it, there may seem to be nothing odd about this: if he has an actual interest in possession, there is no reason to give him a deemed one. But a problem arises where he has an actual interest in possession in part only of the trust property. This can easily happen. If the trustees allow him the use of a residence or of chattels, the terms on which they do so may well be such as to give him, at least in the eyes of the Capital Taxes Office, an interest in possession in the chattels or the residence. The result seems to be that the deemed interest in possession is lost not only in relation to the chattels or residence (which does not matter) but also in relation to the rest of the trust property (which may matter considerably). This seems to make no sense and must surely be wrong in policy.

The example just given serves to expose a small subsidiary problem. When section 89 says that it applies only to trusts "under which, during the life of a disabled person, no interest in possession . . . subsists," does "subsists" mean "currently subsists" or "can in any circumstances subsist"? Does the mere fact that (for example) the trustees could allow the disabled person to reside in a dwelling on terms which would give him an interest in possession mean that the trust falls outside section 89 from the start, or does the section apply in the normal way until they actually do so (at which time, presumably, the section ceases to apply but, one hopes, not retrospectively)? The second alternative is more palatable than the first, but it is not self-evidently the correct one. In practice, no doubt, trusts designed to fall within section 89 will incorporate a "safety net" clause restricting the trustees' powers to whatever (uncertain) extent is necessary to ensure compliance with its conditions. Such a clause should, of course, preserve the doubts inherent in the section, not seek to resolve them.

Capital gains tax

(a) The rules themselves

The Taxation of Chargeable Gains Act 1992, Sched 1, para. 1,⁽⁷⁾ applies (to quote sub-paragraph (1)) where:

"[f ] or any year of assessment during the whole or part of which settled property is held on trusts which secure that, during the lifetime of a mentally disabled person or a person in receipt of attendance allowance or of a disability living allowance by virtue of entitlement to the care component at the highest or middle rate-

(a) not less than half of the property which is applied, is applied for the benefit of that person, and

(b) that person is entitled to not less than half of the income arising from the property, or no income may be applied for the benefit of any other person."

Mental disability is defined in the same way as under section 89, and it will be noted that the requirement about the application of trust capital is also the same. Paragraph 1(2), like section 89(3), says that trusts are not disqualified merely because they incorporate the statutory power of advancement.

Paragraph 1(2) also makes it clear that the trusts may be protective trusts of the kind described in section 33 of the Trustee Act 1925 and says that in this case the conditions set out in (1)(a) and (b), quoted above, must be fulfilled not "during his lifetime" but "for the period during which the income is held on trust for him."

One might expect compliance with these elaborate conditions to secure some substantial capital gains tax advantage. In fact, the only consequence is that the trust enjoys the full annual allowance available to individuals instead of the reduced one normally available to trustees.⁽⁸⁾

(b) Policy and problems

Three features of these provisions give rise to difficulty.

Under section 89, the requirements which apply to the beneficiary (that he is mentally disabled or in receipt of an attendance allowance or disability living allowance) must be fulfilled when the property was transferred into settlement. When must they be fulfilled for the purposes of paragraph I? The answer, it has been said, is, during the whole or part of the relevant year of assessment, but this seems less than clear. As a matter of interpretation, the situation which must exist during the relevant year is that the propety is held on trusts which qualify, not that the disabled person fulfils the qualifying conditions which apply to him. The point could become crucial because of a factor which affects both the capital gains tax and the inheritance tax requirements but has not yet been mentioned. Attendance allowance and the care component of disability living allowance are both withdrawn if the person entitled goes into hospital or lives in residential accommodation in circumstances in which all or part of the cost is or may be borne out of public or local funds.⁽⁹⁾

This means that if one of these situations exists at the relevant time (whatever that may be) the tax concessions do not apply unless the beneficiary can qualify on the alternative ground of mental disorder. As a matter of policy this can hardly be right: the requirement that he should be "in receipt" of one of these benefits must surely be intended as a measure of the disability from which he suffers - and this is not changed by his accommodation.

The second problem has to do with the two alternatives set out in paragraph l(l)(b). Is it necessary that one of these should be fulfilled for the whole of the time, or may one be fulfilled for part of the time and the other for the rest of the time? It is submitted that they must be interchangeable in the latter way. If this were not so, it is difficult to see how the second alternative could ever be a real alternative at all, because the only situation in which the disabled person was not entitled to at least half the income, but the income could not be applied for anyone else, would be one in which the income could be accumulated and (save in a case where the disabled person was himself the settlor⁽¹⁰⁾) accumulation could not be required or permitted for the whole period of his lifetime.

The third problem is the strangest. Like the previous one, it involves the requirements of paragraph l(l)(b). Subject only to the possibility of accumulation, the disabled person must be "entitled to not less than half of the income." Such entitlement would give him an interest in possession in at least half of the trust fund - and this would be a clear breach of the inheritance requirements in section 89! On this basis, it follows that trusts cannot qualify both for the capital gains tax and for the inheritance tax concessions. Surely this result cannot conceivably be right as a matter of policy? Its existence strengthens still further the argument advanced above: that trusts ought not to fall outside section 89 merely because the disabled person himself has a partial interest in possession. But does the possibility of accumulation provide any solution to this problem? The answer seems to depend upon whether the disabled person is himself the settlor:

If he is, then the accumulation periods available to him include the period of his lifetime. His settlement could therefore provide that, during this period, the whole of the income must either be accumulated or used for him. Such trusts would seem to fall within both the inheritance tax and the capital gains tax requirements. But a settlement of this kind would be rare, and such trusts might well be thought too restrictive.
If the settlement were made by someone else (as would usually be the case) the trustees could not legally be directed or empowered to accumulate income for the whole of the disabled person's lifetime. To comply with the capital gains tax requirements, therefore, the trusts would have to be such that an interest in possession arose when accumulation ceased to be possible. It is thought that this fact would probably take them outside section 89 from the very beginning, but it is perhaps just arguable that section 89 would apply unless and until the interest in possession actually arose. This takes us back to another question discussed earlier: whether, in the requirement of section 89 that no interest in possession subsists, "subsists" means "currently subsists" or "can in any circumstances subsist." It would seem rash to assume, in the present context, that it meant the former.

Means-tested public funding

The statutory provisions make it clear that the two tax dispensations discussed above are available only for people whose disability is severe, and severely disabled people are likely in many circumstances to qualify for, and to be heavily dependent on, social security benefits and local authority support (which we may lump together under the description of "public funding").

Some types of public funding are means-tested; others are not. Of social security benefits, the most important means-tested one in the present context is Income Support. From 1988 this has replaced the old Supplementary Benefit, and it consists of a weekly income supplement designed to bring resources up to "needs" (as defined). The most important form of means-tested support provided by local authorities is known at the time of writing as Part III Accommodation Funding. This is the cost to the local authority of discharging its statutory duty to provide residential accommodation for those who are in need of care and attention not otherwise available to them - duty which authorities may fulfil either by providing accommodation in a home owned by them (except in the case of the elderly) by meeting the cost (or so much of the cost as is not covered by Income Support) of accommodation in a private home. After April 1993, it is to be replaced by means-tested services and support provided by local authorities under the new Community Care legislation.

These and other forms of means-tested state funding are of vital importance to many disabled people but, because they are means-tested, they are lost or diminished if any significant capital or income can be classed for means-testing purposes as being available to them. This poses an obvious dilemma for parents and others who want to give financial help to such a person. Very few parents are rich enough to provide, from their own resources, for all the needs of a disabled child during his whole lifetime, especially if there are other children to consider. If the only result of giving such help as they can is that the help takes the place of public funding, which is in effect suspended until the help is exhausted, so that the family money is spent but the child gains nothing, few parents will wish to take this course.

What to do?

Naturally enough, therefore, they ask how they can provide financial help without causing the loss of public funding.⁽¹¹⁾ Absolute gifts are out of the question. So are trusts under which the disabled person has an entitlement to income: this is why trusts which give him a real life interest (as distinct from a deemed interest in possession for inheritance tax purposes) are normally ruled out.

So, what about discretionary trusts? Under the rules which governed the (now withdrawn) social security benefit known as Supplementary Benefit, the clear legal fact that a discretionary beneficiary cannot demand income or capital was in effect ignored and he was treated as having an income entitlement and (if capital could be raised) a capital entitlement in accordance with "the real probabilities."⁽¹²⁾ (One wonders what happened if the trustees chose not to behave in accordance with the real probabilities: in practice, no doubt, they were forced to do so.) But when Supplementary Benefit was replaced by Income Support, the position changed: although there are situations in which a claimant is treated as having "notional income" or "notional capital," these do not include his being a potential beneficiary under a discretionary trust. Any income or capital actually transferred to him by the trustees will, of course, be taken into account, but that is all. From this point of view, therefore, a parent could create a discretionary trust to provide a disabled child with security, with benefits in kind and with occasional payments, without fearing that the whole fund would be eaten away before it could pass to his other children and their families. But if Part III Accommodation Funding was needed, the situation was much less happy because means testing in relation to this local authority benefit was governed, not by the new Income Support rules, but by the old Supplementary Benefit rules which were kept in force solely for that purpose. Indeed, a Memorandum of Guidance issued to local authorities goes so far as to say, in relation to discretionary trusts:

"If there is a discretion to release capital, or capital and income, for the benefit of the resident, it would be reasonable to treat the capital value of the trust fund as part of the resident's capital resources. The income released should then be ignored. If there is discretion to release only income . . . the total income releasable . . . should be taken into account as income . . . ".⁽¹³⁾

Many comments might be made about this remarkable passage. One must suffice: God help the other beneficiaries of a discretionary trust if any of them came to be in need of Part III Accommodation Funding. Fortunately the means testing rules to be applied to the new local authority funding which is to replace Part III Accommodation Funding after April 1993 are the same as those which apply to Income Support.

For the immediate future, therefore, the treatment of discretionary trusts seems relatively favourable. But the history of change and inconsistency outlined above gives little confidence for the future. Only a wild optimist would expect a period of stability lasting for the life of an average trust.

The lessons to be drawn

The situation is not helped by the fact that, although a social security decision can be challenged before the Social Security Appeal Tribunal, there is no similar independent appeal structure for local authority assessments. This is exacerbated by one particular feature of the new local authority funding, because it involves the residential care allowance comprised in Income Support being withdrawn and local authorities being made responsible for the care element in funding on the basis of a "needs assessment" which could come to be misapplied as a "means assessment." Although social services departments must provide a complaints procedure, this will not be comparable to the procedure of appeal to the Tribunal - even though, paradoxically, the same arguments may be advanced under both procedures, and perhaps in relation to the same individual.

What lessons are to be drawn from all this? First, that parents and others who wish to make provision for a disabled person by means of a trust must face frustrations, uncertainties and anxieties to which they should not be subjected. Secondly, that the most hopeful type of trust for this purpose is still a discretionary one, since at the moment its mere existence does not jeopardise Income Support and, at least after April 1993, ought not to jeopardise local authority funding. Thirdly, that if the trust allowed the trustees to pay or apply income to or for the disabled person - and it would hardly make sense unless it did so, and it must do so if the capital gains tax concessions are to be obtained - income actually paid to (and perhaps even income applied for) the beneficiary may serve only to reduce his funding. And fourthly, that although there may, for the immediate future, be no harm in the existence of a power to raise capital for the beneficiary, advisers should think twice before giving one because of the catastrophic effect which it might have if means testing rules were to revert to their former severity during the life of the trust.⁽¹⁴⁾

This last point takes us back to the two tax concessions considered earlier. Both of these require that at least half of any capital applied should be applied for the disabled person. In the past it has been clear (and it may again become clear in the future) that from the point of view of means-tested funding there should be no power to raise capital for the disabled person. In those circumstances it follows that, if advantage is to be taken of either tax concession, there can be no power to raise capital for anybody at all. Not only, therefore, are the tax concessions themselves unclear and problematical; not only may they interact in such a way as to cancel one another out; but one at least of the options which both of them appear to offer to settlors may in many cases be set at naught by the rules about means-tested state funding. Disabled people, and those who care about them, deserve better than this.

1. The writer acknowledges with gratitude the help of Gordon R. Ashton, LL. B., Solicitor, with the section of this article which deals with public funding. Mr. Ashton's contribution to Butterworths Wills Probate and Administration Service contains the detail on this subject which the article omits, and information on the whole topic will be found in his book, Mental Handicap and the Law, published by Sweet and Maxwell in 1992. Of the forms contributed by Nicholas Warren to the second edition of Barry McCutcheon's Capital Transfer Tax (1984), Forms 5 and 6 are settlements for disabled persons.

2. If the transfer was made before that date, the relevant provisions are in s.74 of the 1984 Act.

3. By s.1(2) of the 1983 Act, "mental disorder" means mental illness, arrested or incomplete development of mind, psychopathic disorder and any other disorder or disability of mind.

4. Paragraph (c) is added by Disability Living Allowance and Disability Working Allowance Act 1991, Sched. 2 (as from April 6, 1992: S.I. 1991 No. 2617).

5. Inheritance Tax Act 1984, s.53(2). It is arguable that, although this provision covers a case in which the disabled person becomes entitled to trust property or to another interest in possession in it, it does not strictly cover a case in which the property is applied for his benefit; but the principle must be the same and the Revenue would hardly argue otherwise.

6. The words "the settled property" can hardly be construed as meaning "the income from the settled property"- and if they were the result would be that (subject only to any power of accumulation) the disabled person would acquire an interest in possession in half of the fund, which of itself would prevent the s.89 conditions from applying.

7. Sched. 1 has effect by virtue of s.3. Formerly the relevant provisions were in Capital Gains Tax Act 1979, Sched. 1, para. 5, having effect by virtue of s.5.

8. Para. I (1). Sub-paras. (3), (4) and (5) make consequential provisions for cases in which there are two or more settlements.

9. Social Security (Attendance Allowance) (No. 2) Regulations 1975, reg. 4, and Social Security (Disability Living Allowance) Regulations 1991, reg. 9.

10. In which case the accumulation period provided by Law of Property Act 1925, s.164(a), would be available.

11. One way of doing this may be by means of a gift to charitable trust, a subject dealt with in Mr. Ashton's contribution to the Service, and in his book, both mentioned in footnote 1 above.

12. Commissioners' Decision R (SB) 25/83.

13. Residential Homes under Part III of the National Assistance Act: Charging and Assessment Procedures. This Memorandum purports to go far beyond the Commissioners' Decision mentioned in n. 12.

14. This would not preclude full powers for the trustees to make capital payments for defined purposes beneficial to the disabled person, or to acquire accommodation or chattels of which (though they would remain trust property) he could have the use. It is suggested that such powers should always be included - but the need, mentioned earlier, to avoid their being exercisable in such a way as to create an interest in possession, thus jeopardising the inheritance tax concession, should be borne in mind if that concession is relied upon.

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