Dealing with the outstanding loan on loan trusts

They are a tried and tested IHT solution.

However, what is less well understood are the options for dealing with the outstanding loan.

Advice shouldn’t stop at the immediate IHT savings. Extending it to account for what happens to the loan on death ensures that the money ends up in the right hands, and could also avoid untimely tax on bond gains.

Failure to deal with the outstanding loan through a client’s will could mean the executors call it in to settle any liabilities and pay legacies to the estate beneficiaries. The knock-on effect is that the bond backing the loan has to be cashed in, with income tax to pay on any gains.

This situation can be avoided if consideration is given to what happens to the loan on death.

Dealing with the loan on death 

The ‘loan’ is an asset of the estate. Just like any other asset, whether property or shares, paintings or antiques, it can be left in an individual’s will to a specific beneficiary or trust. 

It makes sense for a client who is creating a loan trust to update their will at the same time to ensure that the loan does not have to be called in by the executors, which in turn means the bond does not need to be surrendered, and so a potential income tax bill can be avoided. 

Options for dealing with the loan:

• Leave to a surviving spouse. This would be an exempt transfer for IHT and the widow(er) would have the same options for dealing with the loan as the deceased had during their lifetime.
• Waive the loan to the trust i.e. make a gift of the loan to the trust. This would be a chargeable transfer as the spouse exemption will not apply, even if the widow(er) is a potential beneficiary of the trust. But the trust would be free from debt and the whole fund held for the trust beneficiaries, leaving trustees free to assign the policy, or segments of the policy, to those beneficiaries as and when appropriate.
• Contingency option. A combination of the above two options. The loan could be passed to the surviving spouse if they survive the settlor but otherwise waived in favour of the trust.
• Gift loan to someone else, such as an adult child. Again, this would be a chargeable transfer on the settlor’s death.

Further lifetime planning

While the above actions can prevent an immediate tax charge on the bond, they do not necessarily reduce a client’s IHT liability.

But reviewing their situation regularly during the lifetime could lead to savings.

Over time, their circumstances will probably change. They may no longer need the safety net of being able to access the loan. 

Making a lifetime gift of the loan

If access is no longer needed, they could make a gift of some or all of the outstanding loan. This is sometimes referred to as ‘waiving’ the loan. 

For all trusts except absolute trusts, this will be a chargeable lifetime transfer for IHT, but as long as the amount being gifted is less than the nil rate band available there will be no immediate tax charge. And provided they survive the gift by seven years, it will be outside their estate for IHT. 

Alternatively, they could gift the loan over time using their IHT annual allowance.

Up to £3,000 could be waived each year and this would be immediately outside their estate. 

Once the loan has been fully transferred to the trust, the trustees can simply continue to hold the bond investment, or use it for the beneficiaries. And remember that the assignment of a policy or policy segments to a beneficiary is an option if this would result in a lower tax bill on surrender.

What is a loan trust?

Loan trusts generally follow the same broad structure (although some early versions may include an initial starter gift):

• A trust is created,
• the settlor makes an interest free loan to the trustees,
• the trustees purchase an investment bond with the loaned capital,
• the settlor may recall the loan at any time. 

The benefit of this is that the client can cap their IHT liability as any growth is immediately outside the estate. If loan repayments are spent the estate may even be reduced.

As the money is loaned to the trustees there’s no lifetime transfer for IHT and no gift with reservation. And all this achieved without losing access to capital as the balance of the loan can be recalled.

Of course, the outstanding loan remains an asset of the estate.

Loan trusts are tried and tested, and offer an IHT planning option that allows clients access to capital, but is also flexible enough to adapt to changes in future circumstances. 

However, consideration should also be given to what clients want to do with any outstanding loan that forms part of their estate on death. 

Investment in bonds keeps the ongoing administration of the trust simple, with no tax returns and no requirement to complete the new HMRC online trust register as long as there are no tax events.

Dave Downie is technical manager at Standard Life