Fundamentals of a Loan Trust

Sanlam Discretionary Loan Trust

You have worked out that your children will have to pay inheritance tax on your estate. However, you are not in a position at present to pass funds to them. You might need the funds yourself, perhaps to provide additional retirement income.

You might think it is not desirable to pass funds to your children at present. One of your children might be looking likely to get divorced or needs to improve their financial management.

A loan trust could be suitable in this situation.

What is a loan trust?

A loan trust is an arrangement used in inheritance tax planning. You loan funds to the trust on an interest free basis and they are used by the trustees to invest in an investment bond. Such bonds are more tax efficient for use in trusts than other forms of investment.

The loan is payable to you on demand and the outstanding loan balance remains as part of your estate. However, the growth on the outstanding loan balance is held outside of your estate for the benefit of the trust beneficiaries (e.g. your children or grandchildren).

As the settlor you are able to demand a part repayment of the loan at any time. The way this normally works in practice is that the trustees make regular part surrenders of the investment bond. Such part surrenders that are within a cumulative 5% a year of the original investment in the bond are made on a tax-deferred basis.

The regular withdrawals will provide you with the ‘income’ you require in a tax efficient manner. That is, no tax will be due until the investment bond is fully surrendered.

As the regular withdrawals are made, the value of the outstanding loan (which is part of your estate) reduces. Provided that you spend the ‘income’ then this is working to reduce your estate for inheritance tax purposes. At the same time the growth in the investment bond, which is outside your estate, is increasing.

You will appreciate that this arrangement works best over the long term and is not a short term fix for inheritance tax.

The types of loan trust

There are now four types of loan scheme being marketed:

  • loan only using a bare trust. This would be used where you want to use the arrangement for the benefit of specific children and/or grandchildren. You will not be able to change the beneficiaries.

  • loan only using a flexible/ discretionary trust. This would be used where you want to use the arrangement for the benefit of your children and/or grandchildren but you would like to reserve the right to exclude one or more of these or you want to allow for further grandchildren in the future.

  • gift and loan using a bare trust. The gift would usually be £3,000 as this is covered by the annual exempt amount. The loan would then be whatever amount you decided upon as with the straightforward loan trust. Again this would be for one or more specific beneficiaries.

  • gift and loan using a flexible/ discretionary trust. The gift would usually be £3,000 as this is covered by the annual exempt amount. The loan would then be whatever amount you decided upon as with the straightforward loan trust. The trustees (which could be you and your spouse) would have the flexibility to choose which beneficiaries would benefit from the trust.

Tax treatment of the trust

As the payment into the trust is in the form of a loan, or a loan with a small gift within the annual allowance, there will not be a chargeable transfer on setting up the trust.

Where the arrangement uses a discretionary trust, the funds in the trust will be subject to the periodic inheritance tax charge at each 10-year anniversary. This charge is a maximum of 6% of the value of the trust fund after taking account of any outstanding loan. In many cases, therefore, any periodic charge is likely to be fairly insignificant.

An exit charge may arise where funds are distributed to a beneficiary. However, these will not apply where the value of the trust fund after taking account of any outstanding loan is within the trust’s available nil rate band.

Objectives

The fundamental objectives of each of the schemes are:to reduce the IHT liability that will arise on the estate of the investor;

  • to facilitate the retention of control over and access to the original investment by the investor;

  • to ensure all capital growth on the investment accrues outside the estate of the investor and passes to the beneficiaries free of IHT; and

  • to secure for the investor a right to regular capital payments free of income tax and capital gains tax in their hands.

This shows how a loan plan takes money out of the estate:

Potential Suitability

These loan trusts are potential suitable for those who:

  • have a net estate exceeding the nil rate band for IHT purposes;

  • have investment capital or realisable or transferable investments available;

  • need a source of regular payments from the investment; and/or

  • need to know that they would have access to the whole or such undrawn part as remains of the original capital invested.

Example of the use of a gift and loan trust

Maurice is age 72 and is married to Jenny who is age 68. Jenny is his second wife as his first wife died. Maurice has two adult daughters from his first marriage, both of whom are married with young children. Maurice and Jenny have recently downsized their home and released just over £200,000 of equity.

Maurice would like to make some financial provision for his daughters but at the same time he and Jenny would like to enjoy a bit more income in their retirement.

Maurice decides to invest £206,000 into a gift and loan trust on a discretionary trust basis with the default beneficiaries being his two daughters. He is automatically a trustee and he appoints Jenny and his nephew (a solicitor) as additional trustees. The trustees use the money to apply for an investment bond on the lives of his two daughters.

This is the first such transfer he has made for inheritance tax purposes and the £6,000 ‘gift’ portion is covered by this year’s £3,000 annual exempt amount together with the unused £3,000 from the previous tax year.

The trustees agree to withdraw monthly amounts of £686.66 (4% pa) from the investment bond which are paid as loan repayments to Maurice. As these are within the 5% pa accumulative allowance any tax liability is deferred until the bond is surrendered. Maurice and Jenny use these ‘tax free’ withdrawals as additional retirement income.

Maurice dies 16 years later at age 88. Assuming that the average investment growth on the bond has been 5% pa after charges and the trustees have continued to withdraw 4% each year as loan repayments, then the outstanding loan added back to his estate would be reduced from £200,000 to £67,475. The value of the bond would have grown to £249,556 meaning that some £182,081 is outside his taxable estate.

Maurice had arranged for Jenny to have the right to any outstanding loan repayments. There would be no inheritance tax on the outstanding loan passing to Jenny as this would be covered by the spouse exemption. More importantly, the trustees would not need to surrender the bond to repay the debt to Maurice’s estate.

Jenny could continue to receive monthly loan repayments from the trust until the whole loan is repaid (or on her earlier death), adjusting the amount to suit her needs.

These figures are for illustration purposes only.

Advantages of a loan or gift and loan trust

  • The trust can provide a tax deferred ‘income’ to you as the settlor, that is the loan repayments, provided they are kept within certain limits.

  • The growth on the underlying investments within the trust accumulates outside the your estate fir inheritance tax purposes.

  • You as the settlor can demand the return of the outstanding loan at any time.

  • The very act of taking and spending the loan repayments reduces your estate for inheritance tax purposes.

  • As the settlor you would be one of the trustees and so will have some control over who will eventually benefit under the arrangement.

Disadvantages of a loan or gift and loan trust

  • As most such trusts are established on a discretionary trust basis, an inheritance tax charge of up to 6% can arise at each 10-year anniversary of the trust or when property leaves the trust.

  • When yours loan has been fully repaid, then no further ‘income’ can be provided to you out of the arrangement. It is therefore important to carefully consider the level ‘income’ at the outset so as not to reduce the remaining loan too early.

  • On your death, the trustees will need to repay the loan to your estate. As this will require surrender of the bond it may incur an income tax charge. To avoid this you could include a specific provision in your will leaving the right to future loan repayments to your spouse/civil partner or to the trust.

Pre-owned Assets Tax

In the Regulations and Guidance Note which was issued immediately prior to the pre-owned assets tax (POAT) legislation becoming effective (i.e. 6 April 2005), HMRC confirmed that loan trusts and gift and loan trusts are not subject to the inheritance tax (IHT) gift with reservation rules.

This means that they could be subject to the POAT charge. However, they are not. This is because the loan and the trust need to be treated separately for POAT purposes. This, in turn, means that, because the settlor is excluded from benefit under the trust and the loan is not itself a settlement, the POAT rules do not apply. This has been confirmed in discussions between HMRC and the ABI.


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Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.