What is the difference between a Discretionary and Disabled Person's Trust?
It is helpful to explain discretionary Discretionary means it is up to somebody to decide if you get something. trusts first. A trust A Trust looks after money for a person or a group of people. is “discretionary” if it is up to the trustees whether or not funds within the trust are used for the benefit of any particular beneficiary.
So, for example if a parent was to set up a trust for their descendants, but leave it up to their trustees how the funds are used:
The trustees could then decide to give more to one of the children than the other (perhaps because they regard one as being in greater need);
Or they might decide there is no particular need to pay money out for now, and instead that they will invest the funds until they are needed by one of the children in the future.
A disabled person’s trust is a type of discretionary trust, but with strict limits on what can be done with the money:
- There must be one named disabled person for whose benefit the trust was primarily set up;
- During the lifetime of that disabled person, any money the trustees pay out must normally be paid for the benefit of that disabled person. (It’s “normally” because there is an exception for small payments to other people – the lower of 3% of the trust fund or £3,000 each year.)
Disabled person's trusts are sometimes called vulnerable Being vulnerable means being at risk of harm, or that you need special care because of your age or disability. person's trusts.
“Disabled person” here has a strict definition.
Generally speaking, we would be talking about someone who is receiving specific disability-related benefits, such as
personal independence payment
Personal Independence Payment (PIP) is the name of a benefit that some people with a disability or health condition get. The money is to pay for extra help you might need to look after yourself and to get around. Some people who used to get Disability Living Allowance (DLA) now get PIP instead.
(PIP) or attendance allowance. A full definition of a disabled person or vulnerable beneficiary can be found here
Again, this is still a discretionary trust – it’s still up to the trustees whether, when or how they pay money out of the trust. The restrictions are about who the trustees can benefit with the trust fund.
Advantages of a Discretionary Trust
It’s important to say that, because they’re both discretionary, both types of trust offer a key advantage many people providing for a disabled person are looking for: namely, funds in the trust do not belong to the disabled person and therefore do not affect any means-tested benefits to which they are entitled.
The difference between the two types of trust is how they are treated for
tax
Tax is the money that pays for things like schools, hospitals and the police. There are different types of taxes like income tax, VAT and council tax.
purposes. Broadly, funds in a disabled person’s trust are taxed at the rates that the disabled beneficiary would have paid on the same money; funds in a discretionary trust are subject to a separate tax regime for trusts. Below we consider the specific taxes.
Inheritance tax
Funds in a disabled person’s trust are subject to inheritance tax when the disabled beneficiary dies, as though the property had belonged to them. The rate of inheritance tax is 40%, but no tax is charged on the first £325,000 of an individual’s estate, and other reliefs may be available – for example, an additional allowance for leaving your home to your children, and tax exemptions for money passing to a spouse or to charity. Funds in a discretionary trust are not taxed on the death of any beneficiary; instead, they pay tax every 10 years the trust continues at the rate of 6% (and tax is also paid at a proportionate rate if money is distributed from the trust part way through a 10-year period). The trust will have an inheritance tax allowance of its own, which may be up to £325,000 depending on what other trusts the settlor (that is, the person who gave the money to the trust) has set up and – if they have died – what gifts they made in the 7 years before their death.
The settlor will need to discuss with their advisor which alternative is better in their circumstances. For example:
- If it is unlikely the sums involved Involved is being included in something or taking part in something. will ever exceed £325,000, an advisor might conclude that the choice will make little difference from an inheritance tax perspective, and that other factors are more important.
- For larger sums, it might be helpful to have some money in a discretionary trust and some money in a disabled person’s trust, to take advantage of Taking advantage of someone is when they are being asked to do something, or get something that the other person needs. both the beneficiary’s inheritance tax allowance and the separate inheritance tax allowance for trusts; or it might be desirable to set up more than one discretionary trust, with at least 7 years passing between the first and the second, so that each has its own inheritance tax allowance.
It’s worth mentioning that a gift by will of the testator’s home (or a share in their home) into a disabled person’s trust can qualify for the residence nil rate band - that is, the additional inheritance tax allowance that is available for people leaving their home to their descendants – as long as the disabled person is a descendant of the person who has died.
The same gift going into a discretionary trust won’t automatically qualify for that relief; but the relief could be claimed retrospectively if, within 2 years of death, the trustees transfer the interest in the house to a descendant of the deceased or into a qualifying trust (like a disabled person's trust).
Income Tax
The aim of the tax system is to prevent trusts having an
income tax
Income tax is the money that is taken out of the money you earn every month. It helps to pay for things we all need like hospitals and schools.
advantage. The way that’s done is to say that the trust initially pays the top rates of tax – currently 45% for most
income
Income is all the money you get from things like paid jobs and government benefits.
; but if the income is paid out to a beneficiary who would normally pay tax at a lower rate, they can claim back the difference in their tax return.
With disabled person’s trusts, isn’t normally appropriate to pay the income out to the disabled person each year – primarily because that income may well affect their benefits, but also because it may be unreasonable to expect them to file a tax return in order to claim back the extra tax that was paid. To avoid that, the whole process (working out tax at the trust’s rate, calculating what the tax would have been at the beneficiary’s rate, and then claiming a reduction in the tax bill down to what the beneficiary would have paid) can be carried out within the trust’s own tax return. The net effect is that the trust pays the same rate of tax the beneficiary would have paid on that income; but the process is administratively complex (so much so that it’s sometimes more cost effective to pay the higher rate of tax than to pay the accountant’s fee for the extra work involved).
While having this option is generally an advantage of disabled person's trusts over discretionary trusts, whether the tax saving is worth the additional work (and therefore professional fees) involved will depend on individual circumstances.
Capital Gains Tax
There is one capital gains tax advantage for lifetime gifts into discretionary trusts that you can’t get with a disabled person's trust: holdover relief. Normally, if you give away assets that have increased in value since you acquired them, you pay capital gains tax on that gain at the time of the gift (in the same way you would if you had sold the assets). Holdover relief allows the settlor to agree with the trustees of the discretionary trust that, instead of the settlor paying the tax now, they will pay tax on the whole of the gain since the settlor acquired the asset (together with their own gain) if and when the trustees sell the property. While the tax isn’t written off, the option to defer payment like this can be a really helpful tool for estate planning; and it’s an option that you don’t get with a disabled person's trust.
Once the disabled person's trust is set up, similar comments to those made above apply – i.e. the trustees can opt to pay capital gains tax at the disabled beneficiary’s rate, instead of paying it at the trust rate.
Converting to a Disabled Person's Trust
If you want to change your Discretionary trust to a Disabled Person's Trust (DPT), we can normally convert it subject to eligibility criteria being met.