Loan Trusts for Inheritance Tax Planning
A loan trust is a way of setting up a trust for inheritance tax (IHT) planning whilst allowing the settlor (the individual who sets up the trust) access to the original capital.
What is a loan trust?
This trust is set up by the settlor who lends monies to the trustees who then invest these monies normally into a life assurance bond. Most companies offer these on either an Absolute or a Discretionary trust basis. Loan trusts can be set up on a single or joint basis.
You may find these suitable for clients who want to do IHT planning but are not ready to give up access to their capital at this point in their lives.
The outstanding loan is available to the settlor at any time, it is interest free and repayable on demand. Don’t forget that if the trust fund comprises a bond, the settlor can take the loan repayments in the form of the 5% tax deferred withdrawals if a regular payment stream is required. Alternatively, the settlor can take lump sums out at any point when required or leave the asset intact until some future date.
What about IHT?
The structure of a loan trust is such that the client is not making a transfer of value when it is set up. Remember it is a loan and not a gift that is the initial transaction with the trustees. All the growth on the investment is outside of the client’s estate from day one!
Waiving the Loan
Loan trusts are very flexible and the outstanding loan can be waived in any amount and at any time. An IHT planning idea for a client is to waive the £3,000 annual exemption each year. If a joint settlor loan trust is set up this can amount to £6,000 every year and soon accumulates. That will be £60,000 over ten years and for IHT purposes these are exempt transfers - not Potentially Exempt Transfers (PETs) or Chargeable Lifetime Transfers (CLTs) and are immediately outside of the client’s estate.
If, at some point in the future a client decides that they no longer need all of the outstanding loan they can waive larger lump sums into the trust for the benefit of their beneficiaries as follows.
Potential Exempt Transfers (PETs)
Under an Absolute Loan Trust, any amount waived creates a PET and if the settlor survives for seven years from the date of waiving it becomes exempt from IHT. If the settlor dies within the seven years, the value of the amount waived will be included in their IHT calculation.
Under an Absolute Loan Trust, the beneficiaries can demand their share of the trust fund once they reach age 18 (16 in Scotland) 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 divorce or bankruptcy. If an absolute beneficiary dies the trustees have to look at their will or follow intestacy rules to see who will now benefit. It is only the trust fund and not any outstanding loan that the beneficiary has entitlement to.
Chargeable Lifetime Transfers (CLTs)
Under a Discretionary Loan Trust, any amount waived creates a CLT which may attract an entry charge if the value of the amount waived when added to any other CLTs made in the previous 7 years exceeds the current nil rate band. Again CLTs drop out of the cumulation after seven years.
Under a Discretionary Loan 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. They may want to lodge a letter of wishes with the trustees to give them some guidance after their death as how they wanted the trust fund divided up. Remember the beneficiary cannot demand monies from the trustees nor does this form part of their estate for divorce or bankruptcy. Again the trust fund does not include any outstanding loan belonging to the settlor.
PETs and CLTs
PETs and CLTs 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.
Loan Trust in Action
Let’s take a look at Rodney and Cassandra who over the years have amassed modest assets but nevertheless have a potential IHT liability. They have approached you to undertake some IHT planning. They want to put money aside for their daughter Joan and her family and also their nephew Damien. Both of the main beneficiaries were a bit wild in their childhood so they do not want to hand over cash directly to them at the moment. Rodney and Cassandra would like the trust fund to be used mainly for their grandchildren should they go to university however they also want the option of being able to help out Joan and Damien throughout their lifetime. They are also aware of their own income levels when they retire in a couple of years and want the option to be able to take a regular payment stream should it be required. They both contribute to company pensions but are financially cautious
One recommendation is for Rodney and Cassandra to take out a Discretionary Loan Trust. This will meet their objectives as follows –
They have a variety of beneficiaries who they potentially want to benefit but they want to retain control over when and to whom the trust assets are paid thus a discretionary trust is perfect for their purposes. There is normally a built in class of beneficiaries within a discretionary trust which include children and remoter issue. If they want to include their nephew, they can either add his name into the beneficiary box or insert a class which will include him. It is suggested to them that they complete a letter of wishes which is a letter written to the trustees. This letter explains to the trustees what the purposes of the trust fund are i.e. helping grandchildren with the costs of university and helping Joan and Damien out if they are struggling with finances. The letter is non-binding on the trustees but will just give them guidance in case the settlors are mentally incapable or dead at the timing of distributing the trust assets.
Rodney and Cassandra are cautious about giving up all of the access to the funds in case they need cash in retirement. Under a loan trust, they have access to all of their original capital at any point in time. So, if in a couple of years they decide they need funds to supplement their retirement income they have the ability to take either regular repayments of the loan or ad hoc payments whichever suits.
In respect of IHT planning, a loan trust will cap their estate immediately and any future growth on the loan trust assets will accrue for the benefit of the beneficiaries and will not be included in their estate for IHT purposes. At any point they have the facility to waive any part of the loan, so, if they decide in the future that they actually do not need to supplement their income, they can waive some or all of the loan into the beneficiaries pot. The waiving of the loan will create a transfer of value at the date of the deed and will start the 7 year clock. They are informed that if the amount waived when added to any previous CLTs in the last 7 years exceeds both their nil rate bands there will be an entry charge to pay.
In the meantime, as Rodney and Cassandra do not normally use up their £3,000 annual exemption, they have decided to waive these within the loan trust. They will be added to the beneficiary pot each year increasing its value and maximising their IHT planning. They like the idea that the £6,000 will not be a CLT and will be immediately exempt.
They have decided to take out a joint settlor loan trust so that on either death the loan will continue to the survivor of them. When second death occurs, any outstanding loan will become an asset of the deceased’s estate and will be distributed in accordance with their will or intestacy. Rodney and Cassandra are definite that the outstanding loan should remain within the trust on both their deaths. Some insurance companies offer a box that can be ticked when the trust is created so that this is an automatic process. This saves time for the trustees as they do not need to wait on probate to deal with the outstanding loan. Subject to insurable interest requirements, they may consider setting up the bond with younger lives assured in order that the investment will continue when they die. Don’t forget that the outstanding loan will form part of the estate of Rodney or Cassandra on second death.
As you can see loan trusts are very versatile and allow clients access to their original capital should it be needed. The growth is outside their estate from day one. Should they decide at some point in the future that they don’t need access to the loan this can be waived at any time and for any amount up to the outstanding loan. The amounts waived start the 7 year clock if they are not exempt.
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