Personal Injury Trusts

In this article, I look at the, often misunderstood, topic of personal injury trusts. I’m frequently asked how a personal injury trust is taxed or what investments might be suitable investments for the trustees; however, a personal injury trust is not, in fact, any particular or special form of trust and much will therefore depend on how the trust has been structured.

The term ‘personal injury trust’ is largely a generic one given to a trust that has been established to hold/receive a personal injury award. Such trusts may consequently take any number of different forms with bare and discretionary trusts being the most common. The individual receiving the compensation and/ or damages generally makes the decision to place the assets into the trust and personal injury trusts will usually therefore be treated as having been created by the claimant (a self-settlement).

As the person who has received the funds (and who is deemed to be the settlor) will be able to benefit from the trust fund; the trust will be settlor-interested for tax purposes. This means that even if the trust is not established as a bare trust, income and gains will be assessed on the injured party in any event under the settlor-interested trust rules.

Likewise, the funds will remain in the estate of the injured party as a gift with reservation regardless of the type of trust (although if the trust is other than a bare or disabled persons trust – see below – the injured party will also be deemed to have made a chargeable lifetime transfer when the trust is established).

The main motivation in placing a personal injury award into a trust is not therefore likely to relate to securing any tax advantage. Instead, the main benefit obtained by using a trust to hold a personal injury award is that the injured party’s eligibility for means-tested benefits is preserved both now and in the future. The use of a trust wrapper i.e. where the funds are invested and managed by trustees may also help to preserve funds for the individual’s long-term benefit and upkeep.

Without use of a personal injury trust, compensation and/ or damages received as a result of a personal injury will be taken into account when determining the claimant’s present or future eligibility for means-tested benefits (although they are disregarded for the first 52 weeks after the award). As the lower threshold for receiving means tested benefits is currently £6,000 (and the maximum £16,000), any compensation received in excess of £6,000 could affect any entitlement to means tested benefits if a personal injury trust is not established to hold the award within 52 weeks of the award (or interim award) being made.

Personal injury trust funds are also disregarded for a local authority care assessment should the individual start to require, or be in, residential care. Note that the deliberate deprivation of assets rules do not apply where funds are placed into a personal injury trust.

 

 

 

Possible structures for a personal injury trust

Bare trust

A bare trust is likely to be the most appropriate option where a personal injury award is made to a minor.

As a minor cannot establish the trust him or herself, the child’s parent(s) will usually establish the trust. In this capacity, they are acting as the child’s legal representative (rather than as parent), so the parental settlement provisions will not apply and income and capital gains accruing to the trust will be assessed for tax against the absolutely entitled minor beneficiary. The trust assets will also form part of the beneficiary’s estate on death and will therefore be distributed in accordance with the intestacy rules (or, if relevant, the terms of the beneficiary’s Will); and are potentially subject to inheritance tax on the beneficiary’s death if the value of the fund exceeds £325,000.

Bare trusts will also often be the default option where an application is made to the Court of Protection to establish a trust for an individual who lacks mental capacity i.e. as an alternative to the Court appointing a deputy to receive and administer the compensation monies. Assets administered by the Court of Protection will be ring-fenced for benefits and care assessment purposes and so a trust will not offer any additional benefits in this respect, however, if the award is held in trust:

• A wider range of investments may be available and the trustee, working with their chosen advisers, can determine the asset allocation of such investments, potentially leading to higher returns; and
• Decisions can be taken without reference to the Court, with potential time and cost savings.

Note that while a bare trust (like any other trust) will ensure that the award is not taken into account in any financial assessment of the beneficiary’s means, it is unlikely to offer any protection of assets in other circumstances such as bankruptcy, separation or divorce.

Interest in possession trust

An interest in possession trust is one where one or more named beneficiaries have an entitlement to any income that is generated by the trust investments. In the case of a personal injury trust, the interest in possession beneficiary will usually be the recipient of the award yet his or her income interest will not affect eligibility for means-tested benefits by virtue of Paragraph 15(5A)(c), Schedule 9, Income Support Regulations 1987.

As the recipient of the personal injury award will also need to be able to access the capital value of the award, an interest in possession trust will only be appropriate if it is drafted in such a way as to allow the trustees to pay or apply capital to or for the benefit of the claimant. Even though the trustees will be able to pay or apply capital to or for the benefit of the beneficiary, he or she typically has no entitlement to capital and an interest in possession (or discretionary – see below) trust, may therefore offer asset protection benefits that are not available through the use of a bare trust.  

If the trust fund is invested in chargeable assets, any payment of capital to the beneficiary will constitute a disposal by the trustees for CGT purposes, meaning that the trustees could incur a tax liability unless the part-disposal gain is covered by the trustees’ annual exempt amount (of up to £1,500 in 2024/25) or hold over relief is claimed.

The trust assets will also form part of the beneficiary’s estate for inheritance tax purposes on his death (as a gift with reservation). In addition, there would be potential charges to IHT on entry as well as periodically every 10-years and where capital is distributed from the trust to beneficiaries in the interim.

The exception to this will be where the trust meets the conditions for a disabled trust (see below).

Discretionary trust

If the trustees do not necessarily want to generate and/or distribute all of the trust’s investment income, a discretionary trust structure will offer more flexibility than an interest in possession trust. It will also be a popular choice where there is a desire to include other persons, in addition to the recipient of the award, as possible beneficiaries (such as the individual’s spouse, issue parents or siblings).

Where a personal injury trust is structured as a discretionary trust, income accruing to the trust will initially be assessed against the trustees at the trust rates (39.35%/45% where income exceeds £500), but as the trust will be settlor-interested, the claimant/main beneficiary will ultimately be the assessable person and will be able to reclaim some or all of the tax by the trustees. As with an interest in possession trust, capital gains will be assessed on the trustees on sale or distribution of chargeable assets although such gains may be offset by the trust’s CGT annual exempt amount (up to £1,500 in 2024/25) or held over.

For inheritance tax purposes, the value of the trust fund will form part of the claimant beneficiary’s estate on his or her death as a gift with reservation. Additionally, unless the trust meets the criteria for a disabled person’s trust (see below), the trust will be subject to the relevant property regime. This means that depending on the values involved, there could be IHT charges on entry, periodically every 10 years and where capital amounts are distributed or used for the benefit of the beneficiaries.

Disabled person’s trust

Where the claimant of the award meets the definition of a disabled person, a number of tax advantages can be secured by structuring the personal injury trust to meet the criteria for a disabled trust. Since 22 March 2006 self-settled trusts have been able to qualify as disabled persons trusts provided that the injured party meets the definition of a disabled person (see below) and the trust has been drafted to ensure that the disabled person is the only person for whose benefit trust property may be applied during his or her lifetime. As long as the trust meets these conditions, a disabled trust can be established on an interest in possession or a discretionary trust basis.

A disabled person is defined as someone who is either:

• Incapable of managing his own affairs due to a mental disorder
• In receipt of Attendance Allowance
• In receipt of the Disability Living Allowance care component at the higher or middle rate and/ or the mobility component at the higher rate; or
• In receipt of Personal Independence Payment.

The main advantages of establishing a discretionary trust that satisfies the conditions for a trust for the disabled are that:

• the disabled person is deemed to have a qualifying interest in possession (even where there is no actual interest in possession), so there is no transfer of value when the trust is set up if the disabled person is also the settlor; and
• there are no IHT periodic or exit charges on the trust.

Trustees of a disabled trust can usually avoid paying tax at trust rates by electing for vulnerable beneficiary treatment to ensure that the income and gains of the trustees are assessed to tax with reference to the beneficiary’s tax position. However, where a disabled person’s trust is established with a personal injury award, the claimant will be treated as the settlor and any income arising to the trust will therefore be taxable on the claimant under the settlor-interested trust rules and a vulnerable beneficiary election will not therefore be necessary. That said, it may still be worth making one for capital gains tax purposes where the settlor is a basic rate taxpayer as although trustees of a disabled trust will typically have a full annual exemption, they will pay CGT on gains made above this at rates of 20/24%.

Payments from the trust

When assessing eligibility for means-tested benefits, no account is taken of either the capital value of assets held in a personal injury trust, or any income generated from the damages award - even if it is paid out to the beneficiary (paragraph 15(5A)(c), Schedule 9, Income Support Regulations 1987).

However, if income is paid out and retained for any length of time in the injured person's hands, it may be regarded as having converted to capital that can then be taken into account. This may be a disadvantage where an interest in possession trust has been chosen and the trustees have invested the trust fund in income-producing assets as the injured person will be entitled to all income from the trust as it arises - so if it is not all spent, the accumulated surplus inadvertently disqualify them from means-tested benefits in the future.

Large distributions of capital from the trust fund could also affect entitlement. If therefore there is a desire to make payments to the beneficiary, these should be below the relevant capital limit if means tested benefits are to be retained.

Payments for the purchase of personal items and most larger items (such as a car or holidays) will be disregarded for benefit purposes provided the beneficiary’s benefits are used to cover day-to-day living costs. Such payments can also be made directly by the trustees to prevent the payments flowing into the injured person's hands where they could become assessable for means-tested benefits purposes.

If the personal injury trust is no longer required, the trustees can dismantle it. Funds paid from the trust may, obviously, then affect any means tested benefits that the beneficiary receives or may receive in the future.

Conclusions

As can be seen from the above, personal injury trusts can take many different forms and a copy of the trust document will therefore be key when considering the most appropriate investment recommendation for existing trusts. Remember also that while income would ordinarily be assessed on the beneficiary as he/she will generally be the settlor of the trust, if the trust is a structured as a discretionary trust (which will frequently be the case) the income will first be assessed at the trust rates. This will have administrative and reporting implications for the trustees and there could therefore be a case for non- income-producing assets in such circumstances.

Where an award has been or is soon to be made but no trust has yet been established and the claimant meets the definition of a disabled person, it will usually be in the best interests to use a disabled person’s trust to hold the award – especially for a large settlement which is expected to remain in place for many years as the tax savings made over time may be substantial.