A number of providers operate “loan trusts” or “gift and loan trusts” which enable individuals with a capital sum to invest to achieve the following:
- All investment growth from the bonds falls outside of the settlor’s estate.
- The ability to enjoy tax free income of 5% per annum for 20 years as the loan is repaid.
- The ability to access on demand all or part of the remaining capital invested by early repayment of the loan (although this may create a Chargeable Event to occur if it exceeds the cumulative 5% allowance).
The Loan Trust would work like this:
- Initially a trust is established often with a small gift i.e. £3,000, so that it stays within the yearly Inheritance Tax exemption. Any gift should be an outright gift to the beneficiaries which is held by the trust and invested by the trustees. The trustees are the investors so they have complete control over where the money is invested and who is the beneficiary or beneficiaries.
- The settlor creates a Flexible Loan Trust with a loan to the appointed trustees (which can be their beneficiaries). Other beneficiaries, such as grandchildren are ideally named as specified beneficiaries.
- Having established the trust an interest free loan for a much larger amount is then made to the trustees and this is invested by them in an investment bond and this can be held offshore to benefit from tax deferred growth during the plan’s lifetime.
- Normally the loan is repaid by way of monthly instalments which can be left until the settlor needs the income, since the 5% pa allowance is cumulative and can be taken at any time or not at all, dependent on requirements. Usually 5% per annum of the amount originally invested is taken as income and ideally repayments are spent or gifted via IHT yearly allowances. This is not liable to income tax in the hands of either the settlor or the trustees. This 5% continues until the loan is repaid but the loan can be repaid at any time, by demand.
- Each year the investor completes a deed renouncing the right to the IHT annual exemption amount of £3,000 of loan. This £3,000 is then held by the trustees within the trust as a gift instead of a loan. No encashment is necessary for this. The settlor gives the trustees a letter stating that this is an annual intention.
- Utilising the trust fund to take advantage of £3,000 gift allowance frees up other income to make gifts out of normal expenditure where possible (subject to normal criteria), further improving the IHT situation.
- The balance of the loan, less any £3,000 gifts within the trust fund, can be drawn at any time in full, thus allowing access to capital if the need arises, such as Long Term Care requirements.
- All investment growth in the trust belongs to the beneficiaries and is outside of the settlor’s estate for Inheritance Tax purposes.
- The outstanding value of the loan remains within the settlor’s estate for IHT purposes. However, depending on the settlor’s circumstances it is possible to revoke part or all of the loan by utilising a deed. If the trust has been set up on a discretionary or interest in possession basis, revoking the loan will be regarded as a Chargeable Lifetime Transfer. Conversely, if the trust has been set up on an absolute (sometimes referred to as “bare”) basis, revoking the outstanding loan will be regarded as a Potentially Exempt Transfer.
- On the death of the settlor, the beneficiaries of the Will may prefer to take instalment repayments of any balance of outstanding loan by continuing 5% per annum withdrawals.
- On the loan being fully repaid to the beneficiary of the Will then, if required, further payments could continue to be made to the Will beneficiary who is also a trust beneficiary .
- The value of the trust fund (growth) is included in grandchildren’s estates for IHT. This prevents compounding any IHT liability for the children of the settlor.
- Any outstanding loan amount is deducted from the value of the trust assets prior to comparing this to any available Nil Rate Band for any periodic charges applicable.
- On the death of the settlor, the amount of outstanding loan will be included in the estate for IHT purposes, but for each year that they survive, the amount of loan to be included in the estate has reduced by the 5% taken (and spent or gifted) as well as the annual £3,000 exempt transfer.
- The arrangement can be set up under an absolute (bare) trust, a discretionary trust or a flexible interest in possession trust.
A “loan only” trust is similar to the “gift and loan” trust above, except there is no gift made, only an interest-free loan to the trustees which is repayable on demand.
Advantages of a Gift and Loan Trust
- This type of arrangement is unlikely to be caught by the Pre-Owned Assets Tax rules, (POAT) or by the Gift With Reservation rules (GWR) since a loan is not a gift which the settlor can benefit from in the future.
- The making of the loan does not constitute a “transfer of value” for inheritance tax purposes.
- The scheme does not have to end when the settlor dies. In order to avoid any trustees’ tax after the settlor’s death, they can assign segments of the investment bond to the other beneficiaries for no consideration. To ensure continuity of the bond after death it may be appropriate to write the investment bond on a Capital Redemption basis, where there are no lives assured, so that it remains property of the trust.
- Appropriate use of a Gift and Loan scheme can allow an investment bond to accumulate at arm’s length from the settlor’s estate to ensure inheritance tax efficacy without compromising access in the future should circumstances change.
Disadvantages of a Gift and Loan Trust
- The part of the loan which has not yet been repaid stays within the settlor’s estate for inheritance tax purposes.
- It can take a long time to be effective and may be more suitable for a younger settlor in good health with a life expectancy of at least 20 years. Even if the maximum 5% withdrawals are taken, the loan repayments take 20 years to be repaid and hence removed from the settlor’s estate.
- If the trust is set up on a discretionary or an interest in possession basis, it may become liable to periodic or exit charges. However, any outstanding loan amount is deducted from the value of the trust’s assets when working out these future charges.
- The settlor could outlive the 20-year loan repayment period, at which point their income will stop.