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TaxationWeb by Bob Fraser MBE, MBA, MA, FPFS, TEP

Bob Fraser, MBE, MBA, MA, FPFS, TEP of Towry Law Financial Services Ltd provides an introduction to loan trusts and their potential inheritance tax implications.

Aim

This is another is a series of articles intended to introduce readers to potential solutions to inheritance tax planning. As always, individual circumstances will require individual solutions, and expert financial advice should always be sought.

Background

The inheritance tax (IHT) ‘gift with reservation’ rules have made it difficult for clients to achieve an inheritance tax saving whilst retaining an income or future benefit from their assets. However, there are accepted measures that can be used to solve this difficulty.

My last article, on discounted gift trusts, explored a solution for individuals who have excess capital that they do not require as capital, but from which they do need to draw an income.

This article looks at a potential solution for individuals who have capital from which they do not currently need an income, but which they may need to access in the future.

Suitability

A loan trust may be suitable for:

• Individuals who have total assets in excess of twice the nil rate band of inheritance tax, and who are already using the nil rate band in their wills on the first death.

• Individuals who wish to reduce the future growth of their estate so as not to add to the IHT liability, but who do not wish to gift assets.

• Individuals who have surplus capital which is not currently needed to support their life-style, but to which access may be needed in the future.

How the Trust Works

This article is only going to look at using liquid assets to loan to this trust. Whilst other assets may be suitable, there are other issues to consider which are beyond the scope of this article.

A solution to the problem of trying to reduce excessive growth in an estate whilst maintaining access to the capital is to use a specially designed inheritance tax loan trust. Under this plan the individual is able to make an interest free loan repayable on demand, the proceeds of which are placed in a single premium life assurance bond written in trust for the chosen beneficiaries. As the bond grows in value (assuming that it does) the growth will fall immediately outside the individual’s estate for the benefit of his/her beneficiaries. There is no requirement to survive for any period of time.

As the interest free loan is not a gift for inheritance tax purposes there is no potential inheritance tax charge on setting up the trust. However, it needs to be remembered that the value of the gift will remain inside the estate.

There is provision under the trust that the trustees (who would typically be the settlor, a spouse and perhaps beneficiaries) make withdrawals from the bond in order to repay the loan over a period of time. These regular withdrawals could be used to provide an ‘income’ each year. These withdrawals can be implemented from the inception of the trust, but if that is the case, then one needs to question the effectiveness of the loan if the withdrawals excessively limit the potential for growth

Recalling the Loan

The settlor can ask for the loan to be repaid at any time. It should be noted that there is a possibility that where the value of the fund falls and the loan is called in at a time when the fund is not adequate to meet the repayment, the trustees may be personally liable for the shortfall. It is the Trustee’s responsibility to cease withdrawals from the policy once the outstanding loan has been repaid.

Forgiving the Loan

The settlor can choose to forgive the outstanding loan at any time. By forgiving the outstanding loan the settlor would forego access to the policy but would be making a gift for IHT purposes. This would then become a potentially exempt transfer (unless settled into a discretionary trust).

Tax

The person setting up the trust can obtain withdrawals up to the value of the outstanding loan subject to the tax treatment outlined below. On death or earlier encashment of the bond, an income tax charge may be incurred should the settlor be liable to higher rates of tax. The details of this are as explained in the article on Discounted Gift Trusts. In addition to setting up the bond on the life of the settlor, the bond can be written on the lives of the beneficiaries, the settlor's spouse, or other arrangements. In this way the bond can be organised to continue after the death of the settlor. Under current legislation, any gains arising whilst the settlor is alive will be by reference to your tax situation. If, however, a gain is realised in the tax year following the death of the settlor or later, any gains will be taxed with reference to the rate of tax for trusts (currently 40%). This means that the trustees have an additional 20% tax to pay on any gains, as tax at 20% is deemed to have been paid within the fund.

It may be possible to limit tax charges by assigning segments or policies to basic rate taxpayers (beneficiaries) who would face no additional charge on encashments.

Happens on Death?

On the settlor’s death any outstanding loan will form part of the settlor’s estate for IHT purposes. For example if the settlor had originally made a loan of £100,000 and by the time of the settlor’s death £70,000 had been repaid in the form of withdrawals, then assuming this £70,000 had been spent (or else why had it been withdrawn?) £30,000 would remain in the residual estate and potentially be subject to IHT. The value of the bond at the time of death that was in excess of the £30,000 would be free of IHT, since it would have constituted the growth on the bond.

If the bond under the loan trust arrangement had been written on the settlor’s sole life, then the bond would automatically encash. The executors would then repay any outstanding loan to the settlor’s estate (using the example above this would be £30,000), whilst the balance would be payable to the beneficiaries under the trust.

If the bond under the loan trust arrangement had been written on lives assured other than the settlor, it would then continue after the settlor’s death. The executors of the settlor’s estate would have several options. Although any outstanding loan would always potentially be subject to IHT, if the estate were left to the settlor’s surviving spouse the executors could assign the outstanding loan to the spouse without encashing the bond. In this way the spouse could continue to receive withdrawals until the outstanding original loan had been repaid.

If the beneficiaries under the settlor’s estate and under the loan trust were the same. the executors could choose to assign the outstanding loan to the beneficiaries without encashing the bond. The beneficiaries could then be made the owners of the bond and would be free to continue with the bond or else to encash it.

Alternatively the settlor’s executors may wish to call in the outstanding loan to distribute it in accordance with the terms of the settlor’s will, which is likely to result in the encashment of the bond.

Any encashment of the bond may result in a charge to income tax as outlined above.

Procedures

It is important that any assets being put into trust are in the ownership of the settlor (the person creating the trust). For Inheritance Tax where there is one settlor then that person’s spouse can be a potential beneficiary of the trust, thus providing a safety net (assets could be transferred to the spouse if necessary). However, if monies are coming from a joint account I would advise that the person who is not the settlor (the spouse) be expressly excluded as a beneficiary under the trust unless it can be clearly shown that the monies placed in trust are entirely from the settlor’s assets and are not jointly held.

Summary

In summary a loan trust can be effective for:

• Individuals who are concerned about the effects of inheritance tax and wish to put some assets aside so they do not grow in value within their estate.

• Individuals who wish to retain access to the capital and do not want to make an outright gift.

• Individuals who may need to take future withdrawals to supplement their income.

Context and Pitfalls

Proposing for a loan trust plan should be carried out as part of an overall estate planning exercise, since there may be alternative solutions to inheritance tax mitigation that are more appropriate. It has to be realised that the capital lent to a loan trust remains within the estate for IHT purposes. It should go without saying that anyone contemplating such a plan should seek properly qualified independent financial advice from an inheritance tax specialist.

March 2006

Bob Fraser MBE, MBA, MA, FPFS, TEP
Chartered Financial Planner
Registered Trust and Estate Practitioner

Towry Law Financial Services Ltd
Towry Law Group plc

Office Telephone: 028 2563 8563
Mobile phone: 07769880476
E-mail: bob.fraser@towrylaw.com

Authorised and Regulated by the Financial Services Authority