What planning options are there with Loan Trusts?

Loan trusts can be used for a variety of planning strategies. 

IHT planning

Loan trusts are suitable for the ‘conservative’ client who wants to avoid IHT but doesn't want to make significant outright gifts at inception. Setting up a loan trust does not give rise to a transfer of value for IHT purposes (i.e. there is no initial gift).

• Be aware that with a joint settlor loan trust, both settlors are permanently excluded from benefitting from the growth. Consider using two single settlor discretionary loan trusts if each ‘party’ has his/her own funds. In that event, after first death the survivor may be able to benefit from the growth from the trust established by the first to die, at the discretion of the trustees.
  
  
• The trustees need to invest to maintain capital as the trust fund should be at least equal in value to the quantum of the outstanding loan. The trustees could be personally liable for any shortfall. In saying that, wording such as this would normally be included in the trust deed – “A trustee shall not be liable for a loss to the trust fund unless that loss was caused by his/her own fraud or negligence.”
  
  
• Bare/absolute trust structures might be suitable for some clients but for many, the flexibility offered by a  discretionary trust arrangement is attractive. 

Waiving the loan during the settlor’s lifetime

Many settlors of loan trusts find that further down the line they don’t actually need full access to the outstanding loan. They can take withdrawals and give those funds away, but there is another option which does not involve disinvesting from the bond. Bearing in mind that the trust fund is subject to the settlor’s right to repayment of the loan then this option is to waive the loan (in full or part) so that the waived amount then increases the trust fund held for the beneficiaries of the absolute or discretionary trust.

In order to execute a loan waiver, the settlor should complete a deed and the amount of the loan waived will be classed as a gift. The insurance company should be able to provide a deed.

If the waiver amount is not covered by an exemption, it will either be a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT) depending on the circumstances (see below).

Lifetime waivers within the annual exemption

• If a PET or CLT is going to cause repercussions for the settlor’s other IHT planning e.g. exceeding their nil rate band for CLTs, or potentially invoking the 14 year rule with an unwanted PET, then using the annual exemption can be useful. 
  
  
• Waiving £3,000 of the loan will save £1,200 in IHT immediately (or for a joint settlor trust £2,400). Remember also that any part of the annual exemption which is not used in a tax year is carried forward into the following tax year. Loan waivers can be a simple means of utilising the annual exemption.

Lifetime waivers

Lifetime waivers in excess of the annual exemption

The outstanding loan will form part of the settlor’s estate so will be potentially subject to IHT. Waiving part of the loan is a gift and starts the seven year clock ticking to get the funds out of the estate.

If the trust is discretionary and waiving a chunk of the loan into the trust is a CLT, then there is the potential for an entry charge if the cumulative value of CLTs over a seven year period exceeds the nil rate band. In these circumstances it may be preferable instead to give away the right to that part of the loan to a particular beneficiary of the discretionary trust  (e.g. child) to create a PET. The beneficiary will then have the right to recall that bit of the loan in the same manner the settlor had. Alternatively, the settlor could have part of the loan repaid via bond withdrawals and then make an outright gift of those funds to a particular beneficiary. Outright gifts are PETs and so do not trigger an IHT charge when the gift is made.

Waiving part of the loan in an absolute trust is a PET so the settlor needs to survive seven years before the gift falls out of their estate. Death within seven years means the PET “fails” and becomes chargeable. It also means you need to look back seven years from the date of the PET to see if there are any CLTs. If there are CLTs in the seven years before the failed PET there could be further tax to pay on the PET itself (the “14 year rule”). 

Loan trusts – death of the settlor

For a single settlor trust the outstanding loan forms part of the settlor’s estate on their death. Where it’s a joint settlor trust, the right to repayment of the loan shall belong to them jointly while both are still alive and then the loan passes by survivorship on first death, so on death of the second settlor the outstanding loan will fall into the second settlor’s estate.

Assuming the loan hasn’t been waived on death (see below) then different options arise.

• The settlor in his/her will might not have specifically addressed the loan and if not, it will form part of the residue of the estate. The personal representatives can demand the trustees repay the outstanding loan to the estate to then be distributed in accordance with the provisions for the residue. Remember that the excess will remain in trust for the trust beneficiaries.
  
  
• The settlor might however have made specific provision in the will to deal with the outstanding loan. For example, bequeath the funds (IHT free) to the surviving spouse or civil partner. Or perhaps the will might state that an estate beneficiary is now entitled to any loan repayments going forward.

If the settlor dies but the bond continues due to surviving lives assured then it may be necessary to encash the bond to repay the outstanding loan.

• If the trust was set up on an absolute basis any chargeable event gain will be assessed on the beneficiary.
  
  
• If the trust was set up on a discretionary basis then gains arising in a tax year after the settlor’s death will be assessed on the trustees at the trustee rate of tax i.e. 45%. Gains arising in the tax year of a UK settlor’s death will be taxed on the settlor.

Importantly an assignment for “money or money’s worth” is a chargeable event so it’s not possible to avoid the trustee rate of tax on repayment of the loan by assigning segments in satisfaction. The trustee rate of tax can cause complications so in some cases it may be simpler and more tax efficient to have the loan waived on death of the settlor.

Waiving the outstanding loan on death

How is this done? The loan trust deed might contain an option at outset for the settlor to choose for the outstanding loan to be cancelled on death (or the survivor’s death). Failing that, the settlor could make it clear in the will that the loan is to be cancelled.

If the settlor has waived the loan on death it means that instead of the trustees physically repaying the loan to the estate and it being distributed in accordance with the settlor’s will/intestacy, it’s held as part of the trust fund for the benefit of the beneficiaries.

It’s important to understand that the outstanding loan is still included in the settlor’s estate for IHT purposes so there’s no IHT advantage of waiving the loan on death. In fact it could cause problems, so plan carefully. Assume Mr A sets up a loan trust and hasn’t waived the outstanding loan on death. The loan is duly repaid to his estate and under the terms of his will everything passes IHT free to Mrs A. In contrast Mr B sets up a discretionary loan trust and decides that the outstanding loan is to be waived in the event of his death. His outstanding loan is therefore passing into a discretionary trust and therefore the spousal exemption would not apply to those funds.

For joint settlor trusts it is only on the death of the second settlor that the loan would be waived.

Potential advantages of waiving the loan on death.

• The loan is waived on death so there is no need for the trustees to retain the proceeds until the personal representatives obtain probate. With that in mind, a loan trust can be an alternative to a probate trust albeit that growth accrues outside the settlor’s estate with a loan trust.
  
  
• From a chargeable event gain perspective, it can sometimes be advantageous to avoid having the loan repaid to the estate on death. If the loan doesn’t need repaid there’s no need to immediately encash (part of) the bond and trigger a gain.
  
  
• An assignment from the trustees to a beneficiary of the trust (i.e. a gift) does not give rise to a chargeable event which offers more flexibility in controlling the tax on gains.

Potential disadvantages of waiving the loan on death.

• The beneficiaries of the trust may not be who the settlor wanted to benefit from the remaining loan.
  
  
• If a settlor adds to more than one discretionary trust on the same day, these trusts will effectively share a nil rate band going forward for the purposes of periodic and exit charges. If you were to waive the loan on death on more than one discretionary loan trust these would fall under the same day additions rules.
  
  
• If the settlor is looking to make use of the downsizing provisions for the Residence Nil Rate Band (RNRB), remember that assets need to be left to a direct descendant. The downsizing provisions provide a way for any RNRB that might otherwise have been lost due to the disposal or downsizing to be reinstated, as long as other assets are closely inherited.

When deciding whether or not to waive the loan on death a client should consider

• Who can benefit from the trust?
  
  
• Who will benefit from the will?
  
  
• Who he/she wants to benefit from any outstanding loan on their death?

Deed of Variation

If the loan wasn’t waived on death and the estate beneficiary is the same as the trust beneficiary, the beneficiary may prefer to carry out a deed of variation to have the loan waived to the trust.

For a discretionary trust this can prove beneficial in terms of chargeable event gain planning but it also means the waived amount is not in the beneficiary’s estate for IHT, means tested benefits etc, and there is also no need to wait for probate.

School fees planning

A Loan Trust could be used for school fees planning. The trustees can advance amounts (from the growth on the bond) to beneficiaries to meet school fees. The amounts advanced would normally be within the bond's cumulative 5% allowance. Strategies involving assignment of bond segments to particular discretionary beneficiaries aged over 18 may also be considered. Also, consider irrevocable deeds of appointment to particular discretionary beneficiaries under 18 where the parental settlement rules are not in scope.

Lump sum pension death benefits

A Loan Trust could be used as the ‘home’ for pension scheme death benefits. The scheme member would usually provide the scheme administrators/trustees with a letter of wishes. Following the member's death before vesting the Loan Trust would operate as a 'bypass' trust.

Pension planning

The trustees could use their power of advancement to make pension contributions for beneficiaries.