Disabled Beneficiary Trusts – pros and cons

Inheritance tax

The most significant tax to discuss is inheritance tax.

To understand the benefit of a disabled beneficiary trust, it needs to be contrasted with most other trusts, known as “relevant property trusts”:

The ADVANTAGES of relevant property trusts are that they are not taxed in tandem with the tax affairs of any individual, therefore no person’s death leads to a 40% ‘death charge’ on their assets (and this is why they are so widely used in tax planning).

The DISADVANTAGES of relevant property trusts are:

• they suffer ‘entry charges’ at 20% at creation (with a possible further charge topping this up to the 40% death rate if you die within seven years);
• they suffer ‘10 year charges’ at rates up to 6% on every tenth anniversary of their creation; and
• they suffer ‘exit charges’ at rates up to 6% on assets leaving the trust.

All of the above tax charges are generally based on the value of a trust over-and-above the £325,000 inheritance tax allowance (known as the “nil-rate band”) so it is very common for trusts to be established up to this limit. (Indeed if you have not already taken advantage of your nil-rate band, doing so with a relevant property trust could be more attractive than using a disabled beneficiary trust.)

Disabled beneficiary trusts are one of the exceptions to the rule that most trusts are relevant property trusts, and their advantages and disadvantages are more-or-less the opposite of the above, namely:

1. ADVANTAGES: no entry charges, no ten year charges and no exit charges.
2. DISADVANTAGES:

• the trust is taxed in tandem with the beneficiary’s estate, so if when the beneficiary dies the aggregate value of their own estate plus the trust is greater than the £325,000 nil-rate band, tax will be paid at 40%;
• the quid-pro-quo for the fact that there is no entry charge is that the creation of the settlement is taxed, instead, as if it was a gift made by the settlor. Accordingly it will form part of the estate to be taxed at 40% if the settlor dies within seven years. This rate may fall, due to taper relief, if the settlor survives more than three years. And an important thing to realise is that this is no worse than a relevant property trust would have been. It is also no worse – and might be much better – than holding the assets in your estate until your death.
• the defining feature of a disabled beneficiary trust is that a beneficiary with a disability must either receive the income, or that income must be accumulated. Putting this another way, the disabled person does not actually have to receive the income, but if it was possible to pay the income to someone other than the disabled beneficiary, the trust would not qualify as a disabled beneficiary trust. In fact there is a minor exception to this, allowing small amounts to be paid to other beneficiaries, but I do not usually include that provision in trust deeds; and
• the type of disability which counts is defined:
• for mental disabilities by reference to whether someone is capable of managing their property and affairs; and
• for physical disabilities by reference to eligibility for certain state benefits.

Income tax

For income tax, a “Vulnerable Beneficiary Election” can be made if the beneficiary qualifies for certain state benefits. The effect of a Vulnerable Beneficiary Election is to tax the income of the trust at the same rate at which the beneficiary pays tax, rather than at the trustee rate (which is quite high at 45%).

However, even if the trust does not qualify, it is still possible to achieve a similar effect, where the income is actually paid out to the beneficiary. That is because the trustees can give the beneficiary a tax certificate for the trustee rate tax they have paid, and the beneficiary can use that to reclaim the difference between that and their own income tax liability, from the tax man.

Practical Issues

From a tax viewpoint it can be seen that the consequences of a Disabled Beneficiary Trust are not significantly different from an outright gift to the beneficiary. It follows that the decision to make one can depend on non-tax consequences:

1. Trusts separate the control over assets (technically called “legal ownership”) from the benefit from those assets (technically called “equitable ownership” or “beneficial ownership”). If the beneficiary is not themselves capable of managing their own finances this can itself be an important reason to use a trust.
2. There is a degree of protection from assets leaving the family as a result of problems affecting the beneficiary – which arise from the fact that the beneficiary does not own and control the trust’s assets. This could be significant if, for example, the beneficiary dies while the trust is running, loses mental capacity, has matrimonial problems or suffers bankruptcy or other financial problems.
3. There is sometimes also a degree of protection from assessments for means-tested state benefits arising, again, from the fact that the beneficiary does not own the trust assets.

In respect of both (2) and (3) above it is important to recognise that the protections afforded by a trust are not absolute and are subject to change as the law in these areas evolves.