Loan trusts simple or complicated

As it happens, very recently I received a query from a financial adviser which  I quote below, somewhat redacted, but mostly verbatim.

 

“A client’s mother set up a Loan Plan in trust with £100,000 and sadly passed away a few months later. The Loan Plan was waived and passed over to the client (let’s call him Mr W)  who was the sole beneficiary under the trust. £36,000 has been withdrawn and the current value is £132,000”.

 

The question was actually about calculating the 10-year anniversary value of the trust fund for the purpose of IHT reporting. Needless to say, I was obliged to ask some questions, in particular how much of the loan had been repaid to the settlor and how much was waived, by whom it was waved and in whose favour? The use of the term "waving" of the loan implied that it was waved in favour of the  trust.   Or was the outstanding loan gifted to Mr W so that he is now the new lender (stepping in the shoes of the settlor/original lender)?

 

Although the adviser said  that Mr W was the sole beneficiary of the loan trust, upon questioning it transpired that the trust was in fact a discretionary trust (hence the question about periodic IHT charge).   The next question was about the bond withdrawals since the settlor’s death. If the loan was waved in favour of the trust, any subsequent withdrawal payments would have been advancements of capital to a beneficiary. So, what happened?

 

Upon further questioning I was told that “The ownership of the bond was transferred to Mr W  after his mother’s death so the bond was now under the trust " Mr W’s  Loan Trust"  (rather than “Mrs W’s (the original settlor)  Loan trust”) and that  Mr W  has taken £36k of withdrawals since 2014. He has simply taken the 4% (5%) allowances since then”.

 

Oh, the blessed simplicity of bonds, with their 5% tax deferred allowances! So easy to deal with! Needless to say,  after all this  I was still not at all clear on what actually happened  especially if the trust was set up by his  mother, then how is it now a different trust? Is Mr W the new lender or just a new trustee?  I asked for copies of the original loan trust, the “waiver” document and the document transferring the ownership of the bond to Mr W. This is necessary to establish what trust we are dealing with and what is inside the trust. I’m afraid that when considering any legal or tax issues, precision is crucial and words do matter.

 

I have not yet received any documents but the case perfectly illustrates how what is supposed to be a simple IHT plan can be  misunderstood, with potentially serious consequences.

 

 

 

Let's then start with what exactly is a "Loan trust" or "Loan plan" in an inheritance tax planning  context.

 

What is a Loan Trust?

 

A Loan Trust is a so-called “soft”  IHT planning arrangement whereby a settlor makes a loan to the trustees and this loan is invested, usually in an investment bond. There is no immediate IHT saving but the idea is that the growth on the bond will accumulate outside the estate of the settlor and as the settlor takes loan repayments from time to time (funded by tax-deferred withdrawals from the bond), and spends them, his estate will gradually reduce. In practice it seems that a large proportion of such settlors never asks for any loan repayments and so the entire loan remains included in their estate. When the settlor dies, the question is how to deal with this loan. The most common questions that we receive are: Can the executors waive the loan? And: Can the bond be assigned to the beneficiary? What would be the tax consequences? To answer these questions, it is important to understand certain “legal niceties”.

 

The key parties in the arrangement after the settlor's death

 

The key point to remember is that there are, legally speaking, four parties in this scenario. The trustees of the loan trust, the beneficiaries of the loan trust, the executors of the settlor’s estate and, finally, the beneficiary/ies under the will (or intestacy) of the deceased settlor.

 

In practice it is likely that the individuals concerned will often fall into more than one category, indeed often the same people will be included in all four. So, for example, the widow or a child of the settlor may be the executor as well as the trustee of the loan trust as well as being a beneficiary under the will, as well as being one of the beneficiaries under the loan trust (assuming the loan trust is a discretionary trust). What does not help is that often, especially where the widow is the main beneficiary under the will and there is no urgent need for cash, no action is taken to “sort out matters” often  for considerable time and by the time an adviser gets involved, certain opportunities (tax-wise) may have been lost.

Legally, and to ensure that there are no adverse tax consequences, even if the individuals concerned fall into more than category, certain process needs to be followed so that it is clear who is legally entitled to what, especially when the bond is encashed.

 

The role of the executor(s)

 

The executors have a duty to collect all the estate  assets, pay any liabilities and distribute the assets in accordance with the will. The outstanding loan is an asset of the estate. If the executors need cash, say to repay any settlor’s liabilities or pay IHT, they will ask for the loan to be repaid and the trustees of the loan trust will have to surrender the bond to repay the loan.

 

If the executors don’t need the cash to pay the  settlor’s debts, the next step is to look at the will provisions. Ideally, the settlor would have included specific provision in their will dealing with any outstanding loan. This may include leaving the right to repayment of the loan to the spouse or to another beneficiary, or to the existing loan trust (the latter would effectively mean   “waiving the loan”). Note that only a person  who is entitled to the loan can “waive it”. The executors  can only waive a loan if they are so instructed in the settlor’s will. A beneficiary who is entitled to the loan is of course also able to waive it (see later).

If, on the other hand, the settlor has not included any provision in their will to deal with the outstanding loan, it will form part of the residual estate.

 

The usual IHT consequences would follow (i.e. exempt transfer if the loan goes to the spouse  and chargeable transfer if to someone else).

 

If the beneficiary under the will prefers to receive all the cash immediately, the executors would need to ask for the loan repayment and the trustees of the loan trust would need to surrender the bond to repay the loan. In  many cases though the will beneficiary will not  need immediate access to cash (or it may not be an opportune time to surrender the bond) and in such a case they may be happy to continue with the loan arrangement, effectively stepping into the lender’s (settlor’s) shoes. Given that the asset of the estate is the loan, and the executors need to distribute the estate and close the administration they will need to transfer this loan to the beneficiary (as for any other asset being distributed) . This is done by way of an assent. This is a document in writing transferring the outstanding loan (more correctly the entitlement to the loan repayment) from the executors to the beneficiary. No special form  is necessary for an assent (except where the asset is land – not relevant here)  but it needs to be in writing. Trustees of the loan trust should be notified, preferably by sending them a copy of the assent.

 

If the beneficiary under the will does not want to receive his entitlement (whether a specific legacy or residue) they may disclaim it or execute a deed of variation (if within 2 years of the settlor’s death). If they accept the transfer of the loan but later change their mind, they will be free to waive the loan if they so decide. For any planning, therefore, what is necessary is to establish what does the will (or intestacy) beneficiary want to do after inheriting the loan?

 

Options for the beneficiary

 

The following assumes the will  beneficiary is also a potential beneficiary of the loan trust. There are four possible scenarios:

 

• Beneficiary would like the funds but if the trustees surrender the bond, they will be charged at the trust rates on any chargeable event gains. To avoid this the trustees could make an absolute appointment in favour of the beneficiary which would effectively turn the trust into an absolute trust. Once the appointment has been made, any chargeable event gain arising on surrender of the bond by the trustees would be assessed on the absolute beneficiary in accordance with their rates of income tax subject to top-slicing relief if applicable, which is likely to produce a better tax result. The trustees then pay over the cash to the beneficiary, part loan repayment, part entitlement under the trust.

 

• Beneficiary would like the bond to be assigned to them. This assumes that the trustees are happy to make a prior absolute appointment in the beneficiary’s favour (as in 1 above). The danger here is that if the loan is still outstanding then an assignment of the bond would be treated as being for consideration (repayment of the loan) i.e. would trigger a chargeable event as well as potentially bringing the subsequent gains into the CGT net, so this course of action should be avoided. Instead, any outstanding loan would first need to be waived by the beneficiary in favour of the trust (see 3)  and there should be no prior agreement that the waiver is conditional on the assignment. The trustees would need to exercise their discretion and consider all the trust beneficiaries before making an absolute appointment. An assignment from the trustees  to a trust beneficiary does not trigger a chargeable event for income tax purposes, and on subsequent encashment the beneficiary will be taxable  in accordance with their rate(s) of income tax.

 

• Beneficiary (having become entitled to the loan under the will) decides they do not want the funds after all – in which case they could waive  any outstanding loan  in favour of the trust. For IHT purposes this will be a separate settlement created by the beneficiary. They will also be treated as settlor of these funds for income tax purposes.  If the beneficiary is also a beneficiary of the trust, then such a waiver would be a transfer of value (chargeable lifetime transfer (CLT) from them) as well as a gift with reservation from them, so to avoid this they would need to be excluded from future benefit under the terms of the trust. The trustees would then be free to deal with the bond as an asset of the trust going forward. Alternatively,  the beneficiary could assign the benefit of the loan to another individual which would then be a PET and the trust could continue as before with just the lender being another person (who may or may not be a beneficiary under the trust). If this were proposed within 2 years of the settlor’s death, a deed of variation would be a better option (see 4) below.

 

• Beneficiary decides they do not want the funds and do not wish to make a CLT (so a gift by them) to the trust – the beneficiary could execute a deed of variation and provided this is completed within two years from the date of death of the settlor, the transfer will be treated as being made by the deceased for IHT purposes. However, the settlor for income tax purposes will be the varying beneficiary. This means that if the trustees encash the bond any chargeable event gain will be assessed partly on the varying beneficiary and partly on UK resident trustees (in relation to any growth) at the trust rate – assuming that the bond is encashed in a later tax year than the settlor’s death. Of course, this could be prevented by assigning the bond/segments out to a beneficiary who would then be taxable on any chargeable event gain in accordance with their rate(s) of income tax upon encashment.

 

 

What about joint loan plans?

 

Personally, I would not recommend taking out a joint loan plan for a number of reasons.

 

Firstly, if there were joint lenders/settlors, the arrangement would become very complicated should the couple divorce or even separate their finances. If a provider offers joint plan option, this is usually on the basis that both must contribute equally and that any loan repayments must be made jointly to both and that on the death of one, the entitlement to the loan repayment passes by survivorship to the other. That is not always what clients will want. And if the loan agreement is not drafted comprehensively, there may be questions over how the loan should be dealt with on separation  or after death.

 

Secondly, if the joint lenders were both settlors then neither could be beneficiary under the trust.  Remember, the settlors are not permitted to benefit from any growth over and above the loan amount.  This means that once the loan is repaid, then the lender/settlor can no longer benefit and so in the case of joint lenders/settlors that would be it.

           

On the other hand, by having one settlor, the partner or spouse of the settlor could be a beneficiary under the loan trust and potentially benefit from the trust after the settlor’s/lender’s death.

 

Conclusions

 

Loan plans have been designed to make IHT planning simple but often it turns out otherwise.  Here are some ideas to ensure that potential problems are avoided.

 

• When a client has had a loan plan for a number of years and has not taken any loan repayments, ask if they still need full access to the loaned money? If not, they may consider waving the loan to the trust (a CLT if the trust is discretionary) or gifting it to another individual (a PET). In both cases the bond can continue growing.
• ensure that the settlor includes specific will provision (or makes a codicil) in relation to his right to the loan repayment
• if the settlor has died, verify will provisions and discuss options with the executors and beneficiaries
• the easiest way to deal with the loan is where cash is actually required by the executors - surrender the bond and repay the outstanding loan to the executors to deal with as part of the estate. Remember though the tax implications of any surrender by the trustees. If  the surrender  falls in the same tax year as the settlor’s death, any chargeable event gain will be assessed on the settlor, if later, on the trustees
• if the executors don't need the cash, the next steps will depend on what the will beneficiary wants to do - see above.
• What should be avoided at all costs is any  assignment  of  segments/bond in satisfaction of repayment of the loan as this would be treated as an assignment for money or money’s worth, i.e. for an actual consideration, and give rise to a chargeable event – not only on the assignment but also when the segments/bond is surrendered, also bringing the subsequent gains into the CGT net.

 

Hopefully the above will help understanding of these plans and how to avoid confusion.