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7 min read 31 Mar 23
Loan Trusts are for clients who want to carry out inheritance tax (IHT) planning but can’t give up access to their capital. Using a Loan Trust allows clients access to their original capital at any point and in any amount but the growth will not be included in their estate for IHT purposes. For the avoidance of doubt, the outstanding loan remains in the settlor’s/donor’s estate for IHT purposes. A typical scenario is where this is the client’s first introduction to IHT planning. They may not like the idea of giving away, outright, all of their nest egg, so using a Loan Trust allows them to retain control and gives them access to their original capital. The client, for example, can take part repayments of the loan via 5% tax-deferred withdrawals.
Normally there are two types available which are Absolute Loan Trust and Discretionary Loan Trust.
With a Loan Trust, the loan can be waived in part or in full at any time. Insurance companies can offer a “Deed to waive a loan”. This is an excellent opportunity to suggest to clients that they use their IHT annual exemption and waive £3,000pa or £6,000pa in a joint settlor trust. Waiving small amounts at a time allows them to gently give up access to their capital. Larger waivers are discussed below.
The underlying investment is typically an insurance bond.
A Loan Trust normally has to be set up with new monies – you cannot normally use an existing bond to create a Loan Trust. The settlor lends monies to the trustees who in turn buy the bond. It is very important to get the order correct when you are setting up a Loan Trust. The trust has to be created first, the settlor then lends money to the trustees who then buy the bond. It is generally acceptable to have the date of the trust and the date on the application form dated on the same day, as the assumption is the trust was dated earlier in the day, before the application. It is not acceptable to have the bond dated before the trust deed as you cannot set up a bond with trustees who do not exist yet.
You can generally top up an existing Loan Trust and the settlor can do this by either way of a further loan or by way of a gift. Check the wording of the deed if you are unsure.
The settlor has full access to any outstanding loan and NOTHING else. The loan is interest free and repayable on demand. In a joint settlor case the right to repayment of the loan will automatically pass to the survivor. All of the growth and any amounts waived must be held for the benefit of the beneficiaries and therefore the settlors have absolutely no access to the trust fund whatsoever – you will normally find a settlor exclusion clause within the deed along these lines –
5. Settlor exclusion clause
(1) The Trust Fund shall be possessed and enjoyed to the entire exclusion of the Settlor and of any benefit to him by contract or otherwise and no provision of this Settlement and no discretion or power shall operate so as to allow any of the capital or income of the Trust Fund to become payable to or applicable for the benefit of the Settlor in any circumstances whatsoever.
In respect of the beneficiaries this depends on whether it is an Absolute trust or a Discretionary trust that has been chosen.
Under an Absolute trust – the beneficiaries can demand the trust fund once they reach age 18 (16 if written under Scots law) and the trustees are legally obliged to inform the beneficiary that the trust fund exists. The trust fund will form part of the beneficiary’s estate for IHT purposes. If an absolute beneficiary dies the trustees have to look at the will or follow intestacy rules to see who will then benefit.
Under a Discretionary trust it’s up to the trustees to decide who will benefit and when they will benefit from the trust fund. As long as the beneficiary is in the class of beneficiaries, the trustees can allocate funds to them. This is why clients should choose their trustees wisely as ultimately they will be dealing with the trust fund. It is advisable for clients to lodge a letter of wishes with the trustees to give them some guidance, after their death, as to how they want the trust fund divided up. Remember that a discretionary beneficiary cannot demand monies from the trustees nor does this form part of their estate for IHT purposes while inside the trust.
There is no entitlement to the outstanding loan by the beneficiaries.
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 may 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 own fraud or negligence."
This ensures the trustees are not liable for any shortfall in adverse market conditions.
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 CLT’s 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 7 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 10 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. For example.
|Bond Value||Outstanding Loan||Value for IHT Purposes||Reporting Required?|
Yes, because the bond value exceeds £260,000
Remember gifts i.e. PETs and CLT’s eat into the nil rate band in chronological order thus when calculating any IHT liability they will be applied first against the nil rate band.
Don’t forget that any top ups by gift will be either PETs or CLTs from the date of the top up.
Any outstanding loan forms part of the settlor’s estate for IHT purposes.
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