Estate planning with loan trusts

WHAT IS A LOAN TRUST?

A number of clients are not always keen to make gifts during their lifetime because they feel that the funds may be needed in the future. A loan trust allows the settlor access to their original capital, via the trustees, whilst achieving an inheritance tax (IHT) advantage by ensuring that any investment growth inside the trust accrues outside of their taxable estate for IHT purposes, thereby ‘freezing’ the potential IHT liability on the amount lent.

The trust is set up with a loan of cash to trustees. The trustees then invest the loan amount, usually in a life assurance single premium bond (Bond) but sometimes in collective investments, on behalf of the trust beneficiaries.  For the purposes of this article our examples are based on a Bond as the trustee investment. The loan itself is not a gift for IHT purposes as it remains an asset in the individual’s (settlor’s) estate and they can call for repayment of all or part of the loan at any time.

WHEN MAY A LOAN TRUST BE SUITABLE?

• When access is required

IHT savings can be maximised over time by the trustees making loan repayments to the settlor on a regular basis. Tax on withdrawals from the Bond will be deferred if they fall within the cumulative 5% annual allowances.  Provided such loan repayments are spent and not retained in the estate, the taxable asset (the loan) will gradually reduce in value, as will the resulting IHT liability on the estate.

Example

Edna invests £200,000 in a Bond and decides to take 4% annual withdrawals, based on the original premium, from the Bond. Ten years later, Edna dies.  After taking account of withdrawals and assuming a growth rate of 3.5% per annum compound, the Bond is valued at £188,267 after charges.

On Edna’s death, assuming her available nil rate band has already been used, IHT will be payable on the Bond value at 40%, thus incurring an IHT charge of £75,306 (£188,267 x 40%), leaving a net amount of £112,961 (£188,267 - £75,306) which will be distributed in accordance with the terms of Edna’s Will.

However, if Edna had decided, instead, to establish a loan trust and the £200,000 is invested by the trustees in a Bond, the IHT payable on death would only be £48,000 (£120,000 x 40%). The reduction in the amount of IHT payable has taken place because Edna had taken 4% tax-deferred repayments each year (£80,000 in total) which she has spent on her everyday living expenses.  As a result only £120,000, which is the outstanding loan amount, remains taxable in her estate. In addition, all investment growth is outside of her estate from day one as the Bond is held under the terms of the loan trust.  The trust would usually be a discretionary trust but could be a bare trust.                                      

Therefore, by establishing the loan trust the net return is: £140,267 (£188,267 - £48,000) compared to £112,96, an increase of £27,306.

• When access is not required                          

In situations where no ‘income’ is required by the client they may question why a loan trust could be beneficial. However, if the client is wealthy and wishes to prevent their IHT position getting any worse, a loan trust may just be the answer.

In the following example we compare the IHT difference of investing in a Bond which is not held under the terms of a loan trust and one which is held under the terms of a loan trust. The following example assumes the nil rate band has already been used.

Example

Andy invests £200,000 in a Bond and decides not to take any withdrawals from the Bond. Ten years later Andy dies.  Assuming a growth rate of 3.5% per annum compound after charges the Bond has grown in value to £282,120.

As Andy’s nil rate band has already been used, IHT will be payable on the Bond value at 40%, thus incurring an IHT charge of £112,848 (£282,120 x 40%), leaving a net amount of £169,272 (£282,120 - £112,848) which will be distributed in accordance with the terms of Andy’s Will.

Had Andy, instead, established a loan trust and the trustees invested £200,000 in a Bond the IHT payable on death would only be £80,000 (£200,000 x 40%) based on the value of the outstanding loan, as all investment growth is immediately outside of his estate from day one.

By establishing the loan trust, the net return is £202,120 (£282,120 - £80,000).  So, the benefit of having used a loan trust is that there is a lower amount of IHT payable meaning the net return is higher by £32,848 (£202,120 - £169,272).

• Waiving repayment of the loan

Another situation where a loan trust may appeal to a client is where they are unsure as to whether or not to make a gift. In such a situation, repayment of the loan can be waived at a later date - the waiver must be made by deed. If the trust has been established on a discretionary basis this would give rise to a chargeable lifetime transfer for IHT purposes based on the amount of the outstanding loan that is waived

Example

Clive, a widower aged 63, decides to establish a discretionary loan trust and lends the trustees £100,000 which they invest in a Bond.

Clive decides not to take any income withdrawals for the first five years, with the effect that the asset (the loan) is simply ‘frozen’ at its original value. By year six, Clive’s financial circumstances have changed for the better and he decides to waive repayment of the outstanding loan in favour of the trust.  This would give rise to a chargeable lifetime transfer but provided Clive has not at that time made any other chargeable lifetime transfers there would be no IHT payable as the £100,000 would fall within his available nil rate band.  Further, provided Clive survives for seven years having waived his right to repayment of the loan the £100,000 chargeable lifetime transfer will fall outside of his taxable estate. It is vital that a deed of waiver is executed to give effect to this planning objective.

SUMMARY

From the examples above it is evident that this type of trust arrangement could be suitable for those clients who wish to take regular payments or for those clients who want flexible access to a certain amount of capital in the future. In addition, the loan trust may also appeal to those clients who do not require access currently but are unsure whether this will continue to be the case in the future.

OTHER TAX CONSIDERATIONS

Please note that this article has only considered the IHT benefits of establishing a loan trust and not the income tax implications regarding the underlying investment(s). In most cases, the trustees will have invested in a Bond.  So, while regular repayments of any outstanding loan may be covered by the tax-deferred allowances, substantial tax could be payable where, for example, the trustees fully encash the Bond to repay any outstanding loan. For this reason, it is vital that consideration is given in terms of what should happen in respect of any outstanding loan, particularly on death of the settlor, which we will cover in the next article.