Loan Trusts for Inheritance Tax Planning: Everything You Need to Know

loan trust

Inheritance tax is a concern for many individuals who are looking to pass on their assets to their loved ones. One way to minimise the impact of inheritance tax is through using trusts. Trusts are legal arrangements that allow an individual to transfer their assets to a separate legal entity, which a trustee manages for the benefit of the trust’s beneficiaries. Trusts come in different types, and one such type is a loan trust.

A Loan Trust is a solution for individuals who wish to plan for inheritance tax (IHT) but do not want to relinquish access to their capital. By establishing a Loan Trust, clients can withdraw their original capital at any time and in any amount while the growth of the trust remains outside their estate for IHT purposes. However, it is essential to note that the outstanding loan remains in the donor or settlor’s estate for IHT purposes.

This approach is often suitable for individuals new to IHT planning and hesitant to give away their entire savings. Using a Loan Trust provides them with control and access to their original capital, and they can also make part repayments of the loan through tax-deferred withdrawals of up to 5%.

There are two primary types of Loan Trusts: Absolute Loan Trusts and Discretionary Loan Trusts. The former allows for the loan to be waived partially or completely at any time, and insurance companies offer a “Deed to waive a loan” for this purpose. This can be an excellent opportunity for clients to use their IHT annual exemption and gradually give up access to their capital by waiving small amounts such as £3,000pa or £6,000pa in a joint settlor trust. The underlying investment for Loan Trusts is typically an insurance bond.

How do gift and loan trusts work?

Gift and loan trusts are a popular estate planning tool used to minimize inheritance tax (IHT) liabilities while providing financial support to family members or beneficiaries. The trust allows the settlor to lend money to the trust, which is then used to purchase assets that generate income. The beneficiaries receive a regular income from the trust, and the loaned amount can be repaid to the settlor at a later date or on death.

Gift and loan trusts can be set up as either a discretionary trust or an interest in possession trust. A discretionary trust provides the trustees with more control over the distribution of income and capital, while an interest in possession trust gives the beneficiaries an automatic right to receive the trust income.

The settlor can transfer a lump sum into the trust or make regular contributions over time. The trustees are responsible for managing the trust assets and distributing income to the beneficiaries. The beneficiaries can be named individuals, such as children or grandchildren, or a class of people, such as “all grandchildren.”

The settlor can set conditions on the distribution of income and capital from the trust. For example, they may require that the income is only used to pay for a beneficiary’s education or medical expenses. This allows the settlor to provide financial support to their family members while ensuring that the money is used for a specific purpose.

One of the main benefits of gift and loan trusts is that they can be used to reduce IHT liabilities. The value of the loaned amount is deducted from the settlor’s estate for IHT purposes, and any growth in the trust assets is also outside of the settlor’s estate. However, there are strict rules around the use of gift and loan trusts, and it is essential to seek professional advice before setting one up.

In summary, gift and loan trusts are a useful tool for individuals looking to minimize IHT liabilities while providing financial support to their family members. The trust allows the settlor to lend money to the trust, which is used to purchase assets that generate income. The beneficiaries receive a regular income from the trust, and the loaned amount can be repaid to the settlor at a later date or on death. The use of gift and loan trusts can be complex, and professional advice should be sought before setting one up.

Loan Trust structure

A Loan Trust is typically structured with new funds, as existing bonds are not typically used to establish it. The settlor provides money to the trustees, who then purchase the bond. The order of setting up a Loan Trust is crucial, as the trust must be established first, followed by the loan from the settlor to the trustees and the purchase of the bond. It is generally acceptable to have the trust deed and application form dated on the same day, assuming that the trust was created earlier in the day before the application. However, it is unacceptable to date the bond before the trust deed, as it is impossible to establish a bond with trustees who do not yet exist.

It is possible to add funds to an existing Loan Trust, which can be done by providing another loan or making a gift. If uncertain about the wording of the trust deed, it is advisable to check it first.

What happens to a loan trust on death?

When the settlor of a loan trust passes away, the trustees are typically left with two options: they can repay the outstanding loan to the deceased settlor’s estate, or they can keep the loan in place and distribute the trust assets to the beneficiaries.

If the trustees decide to repay the loan, the amount of the outstanding loan will be subtracted from the value of the trust assets before they are distributed to the beneficiaries. This means that the inheritance tax liability on the trust will be reduced, as the value of the trust assets will be lower.

Alternatively, if the trustees choose to keep the loan in place, the beneficiaries will inherit the assets subject to the outstanding loan. In this case, the value of the trust assets will not be reduced by the amount of the outstanding loan.

It’s worth noting that if the loan is forgiven in the settlor’s will, the beneficiaries will receive the assets free of the outstanding loan. However, if the loan is not forgiven, the beneficiaries will be responsible for repaying the loan to the estate.

It’s important to note that loan trusts can be complex legal arrangements, and there are a variety of factors to consider when setting one up. It’s always a good idea to consult with a qualified financial advisor or solicitor before making any decisions about creating a loan trust. Additionally, regular reviews should be conducted to ensure that the trust is still meeting the intended goals and objectives, and to make any necessary updates or changes.

Understanding Access to Trust Funds for Settlors and Beneficiaries

The Loan Trust only provides the settlor with access to the outstanding loan amount, which is interest-free and repayable upon request. In the case of a joint settlor arrangement, the surviving settlor will inherit the right to repayment of the loan. However, the settlor has no access to any growth or waived amounts, as these are held solely for the benefit of the beneficiaries. This is made clear through a settlor exclusion clause included in the deed.

The beneficiaries’ access to the trust fund depends on whether the trust is an Absolute or Discretionary trust. Under an Absolute trust, beneficiaries can demand the trust fund when they reach a certain age, and the trust fund becomes part of their estate for IHT purposes. However, under a Discretionary trust, it is up to the discretion of the trustees to decide when and how to allocate funds to the beneficiaries within the designated class. It is essential for clients to carefully choose their trustees and provide them with guidance on how to allocate the trust fund after their death through a letter of wishes. The beneficiaries have no entitlement to the outstanding loan.

How are loan trusts taxed?

In a loan trust, the settlor lends money to the trust, which then invests the funds to generate income. The trust pays the interest on the loan back to the settlor. This interest is subject to income tax at the settlor’s marginal rate.

The trust can also generate capital gains or income from its investments. Capital gains are taxed at the trust level, while income is taxed at the beneficiary’s marginal rate.

However, there are specific tax rules that must be followed to ensure the loan trust remains tax-efficient. For example, the interest paid on the loan cannot be less than the official rate of interest set by HM Revenue & Customs (HMRC). If it is, the difference may be treated as a gift, which could trigger an immediate IHT charge.

Additionally, if the settlor dies within seven years of setting up the loan trust, the loan’s value is added back to their estate for IHT purposes. This is known as a “gift with reservation of benefit” and means that the assets held in the trust may be subject to IHT on the settlor’s death.

In summary, loan trusts can be tax-efficient to pass wealth to future generations while retaining some control over the assets. However, it is essential to seek professional advice to ensure that the trust is set up correctly and that all tax rules are followed to avoid any unexpected tax liabilities.

Is a loan trust a chargeable lifetime transfer?

When setting up a loan trust, one of the primary considerations is the potential inheritance tax (IHT) implications. A loan trust is a form of trust in which the settlor lends a sum of money to the trust, which is then invested. The trust then pays interest on the loan to the settlor, which is typically set at a commercial rate.

One of the advantages of a loan trust is that it can be used to reduce the potential IHT liability on the settlor’s estate. This is because the loan is not considered a gift for IHT purposes, and therefore, it is not subject to IHT. However, it is essential to note that the loan must be repaid to the settlor’s estate upon their death, or it will be treated as a gift and subject to IHT.

The loan made to the trust is not considered a chargeable lifetime transfer (CLT) for IHT purposes. This means that the loan does not use up any of the settlor’s nil rate band, which is the amount of money that can be tax-free to beneficiaries upon death.

Instead, the potential IHT liability arises from the value of the assets held within the trust. These assets are subject to periodic charges, which are calculated every ten years. Additionally, if a beneficiary receives a payment from the trust, this may also be subject to an exit charge.

Overall, a loan trust can be a valuable tool for reducing potential IHT liability. Still, it is important to carefully consider the tax implications and seek professional advice before setting one up.

Is a loan trust a discretionary trust?

A discretionary trust is a type of trust where the trustees have the discretion to decide how to distribute the trust fund among the beneficiaries. In a loan trust, the trustees hold the trust fund, which is usually made up of a loan from the settlor, for the benefit of the beneficiaries.

While a loan trust is not necessarily a discretionary trust, it can be set up as one. This means that the trustees have discretion over how to use the loaned funds, which can be invested or used to purchase assets that will generate income for the beneficiaries.

The discretionary nature of the trust can provide some flexibility for the trustees in how they manage and distribute the trust fund. For example, if the trust fund includes investments, the trustees can make decisions about when to sell or hold those investments based on market conditions and the needs of the beneficiaries.

However, it’s worth noting that setting up a loan trust as a discretionary trust can also have some drawbacks. For example, the beneficiaries may not have a guaranteed right to receive income or capital from the trust, as the trustees have discretion over how to distribute the funds. This can create uncertainty and potential disputes among the beneficiaries.

In addition, discretionary trusts can be subject to higher tax rates than other types of trusts. For example, if the trustees make distributions to beneficiaries that exceed the available tax-free allowances, the excess may be subject to the highest rate of income tax.

Overall, whether a loan trust is set up as a discretionary trust or not will depend on the specific needs and goals of the settlor and beneficiaries, as well as the advice of their professional advisors. It’s important to carefully consider the advantages and disadvantages of different trust structures before making a decision.

Who pays inheritance tax on a life-interest trust?

A life interest trust is a type of trust in which the trustee is given the power to manage and distribute the trust assets during the lifetime of a specified beneficiary, who is entitled to receive the income generated by the trust assets. Upon the beneficiary’s death, the trust assets are then distributed to the remainder beneficiaries.

When it comes to inheritance tax (IHT) on a life interest trust, the beneficiary who is entitled to receive the income generated by the trust assets is usually responsible for paying any IHT due on their share of the trust. This is because the beneficiary has a “life interest” in the trust, meaning they have a right to the income generated by the trust assets during their lifetime.

However, if the trust was set up so that the trustee can accumulate income and add it to the trust’s capital, then the trustee may also be responsible for paying any IHT due on the accumulated income. This is because the trustee has control over the trust assets and is responsible for managing them following the terms of the trust.

It is important to note that the tax treatment of a life interest trust can be complex and will depend on the trust’s specific terms and the circumstances of the parties involved. It is advisable to seek professional advice from a tax specialist before setting up or dealing with a life interest trust.

Loan trusts Pros and Cons.

Loan trusts have both advantages and disadvantages that should be considered before establishing one. Here are some of the pros and cons of a loan trust:

Pros:

  1. Inheritance Tax Savings: A loan trust is a tax-efficient way to pass assets to your beneficiaries without incurring inheritance tax. It allows you to make a gift of assets but retain an interest in them through the loan arrangement, thus reducing the value of your estate for inheritance tax purposes.
  2. Flexibility: Loan trusts can be flexible regarding who the beneficiaries are, how much is loaned, and when the loan is repaid. The trustees have the discretion to make loans to any beneficiary of the trust, subject to any conditions set out in the trust deed.
  3. Control: As the settlor, you can retain control over the assets by acting as one of the trustees. This can be particularly useful if you have concerns about the ability of the other trustees to manage the trust effectively.
  4. Asset Protection: Assets held in a loan trust can be protected from creditors, including divorce settlements and bankruptcy proceedings, as they are not part of the beneficiaries’ estates.

Cons:

  1. Loss of Access to Capital: Once assets are transferred into a loan trust, you lose direct access to them. If you need to access the capital, you must repay the loan, which may not be possible in some cases.
  2. Loan Repayment: The loan must be repaid with interest, which must be factored into the trustees’ investment strategy. Failure to repay the loan could result in adverse tax consequences.
  3. Administrative Burden: Loan trusts require ongoing administration and record keeping, which can be time-consuming and costly. This includes the annual completion of trust tax returns and any necessary payments of income tax and capital gains tax.
  4. Loss of Control: By setting up a loan trust, you are giving up some control over the assets, as they will be held by the trustees on behalf of the beneficiaries. You will need to trust the trustees to manage the assets effectively and under the terms of the trust deed.

In conclusion, while loan trusts can offer significant benefits in terms of tax planning, they also come with some drawbacks that must be carefully considered before establishing one. It is vital to seek professional advice to determine if a loan trust suits your specific circumstances.

How is a shortfall in the value of a bond handled in a Loan Trust?

If the bond falls in value, the settlor’s loan cannot be fully repaid. Whether the trustees are liable for the shortfall depends on the precise terms of the trust and the circumstances of each case. It might be that a clause will be contained within the deed along the following lines – “A Trustee shall not be liable for a loss to the Trust Fund unless that loss was caused by his fraud or negligence.” This ensures the trustees are not liable for any shortfall in adverse market conditions.

Understanding Inheritance Tax for Loan Trusts

There is NO transfer of value when you set up a Loan Trust; there is no gift, just a loan. Any amounts waived which are not exempt will either be a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT), depending on whether an Absolute trust or a Discretionary trust has been chosen.

Under an Absolute trust, the amount waived (if not exempt) creates a PET which, after seven years from the date of the deed of waiver, becomes exempt from IHT. If the settlor dies within the seven years, the PET becomes chargeable.

Under a Discretionary trust, the amount waived creates a CLT which may (rarely) attract an entry charge if the value of the waived amount, when added to any other CLTs made in the previous 7 years exceeds the settlor’s current nil rate band. Again CLT’s drop out after seven years as long as no PETs are created after the CLT. If a settlor creates a mixture of PETs and CLTs this can lead to a 14-year timeline. If a PET fails and becomes chargeable, it pulls in any CLTs made within seven years of the failed PET, thus potentially going back 14 years. Details are available here.

Discretionary trusts may also be subject to periodic charges every ten years and exit charges. Bear in mind, however, in the case of a loan trust, that the assessable amount would be the bond value, less the outstanding loan. Form IHT100d is used to report to HMRC regarding the 10-year anniversary charge unless the ‘excepted settlement’ rules apply. These rules state that reporting is not required where the ‘value’ does not exceed 80% of the nil rate band. For reporting purposes, the ‘value’ is simply the bond value and is not the bond value, less the outstanding loan.

In conclusion

Understanding the complex world of trusts and taxes can be daunting, but it doesn’t have to be. Our team of experts is here to help guide you through the process and provide tailored advice to meet your unique needs. Whether you’re looking to set up a loan trust or need help navigating the intricacies of inheritance tax, we’re here to help. Contact us today to schedule a consultation and take the first step towards securing your financial future.

About Graham

Accountant specialising in tax, property, and estate planning. A regular speaker at landlord, property Investor, and later life planning events.

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