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What is a loan trust?

A loan trust involves an individual establishing a trust. But rather than making a gift, the settlor lends money to the trust. The trustees then invest this money, typically into an investment bond, for the benefit of the trust beneficiaries.

The settlor can demand repayment of the outstanding loan at any time - this can either be in full or in part. If regular loan repayments are needed, the trustees can repay the loan by using the 5% tax deferred withdrawal facility from the bond. The settlor cannot benefit from the trust fund - any fund growth must be used for the benefit of the trust beneficiaries.

Who is it appropriate for?

A loan trust is typically used for individuals who want to start estate planning, but don’t feel comfortable about gifting away capital in case they may need it at some point in the future.

Creating a loan trust means any investment growth is immediately outside the estate and this can help cap the value of assets included within the estate.

Loan repayments which are spent will further reduce the IHT liability. For example, taking regular withdrawals to supplement income will see their estate reduced year upon year. Larger lump sum withdrawals may reduce the estate more quickly, provided they're not being used to purchase assets which will form part of the estate on death.

If the settlor decides that they no longer need access to all their capital, they can choose to waive the right to the repayment of some or all of the loan. Any loan given away will be a CLT (or PET for absolute trusts) and will be outside the settlor’s estate after seven years, unless covered by an exemption.

Creating the Loan Trust

Typically the creation of a loan trust requires the following steps.

1. The trust is created
2. Loan agreement completed between the settlor and trustees and a loan of cash is made to the trustees
3. Trustees invest the cash from the loan into an investment bond

These are typically all packaged together and included in the provider’s documentation.

Creating the trust

The first step is to create the trust. The trust has to be in place before the loan agreement can be drawn up. A loan trust will typically offer three trust options:

• Absolute trust
• Flexible (interest in possession) trust
• Discretionary trust

Under the absolute trust, the beneficiaries are fixed at outset and cannot be amended by the trustees at a later date. When selecting the absolute trust, the settlor should be certain of who they ultimately want to benefit from the trust.

The flexible trust names the beneficiaries who are entitled to any trust income. However, if the trust is invested in an investment bond, no income is produced. The trust includes an overriding power of appointment which allows the trustees, which will usually include the settlor, to alter the beneficiaries or their respective shares in the trust. This is especially useful where the settlor may want to alter the beneficiaries in the future. For example, where there are new beneficiaries born after the trust is created, such as grandchildren, or perhaps where the named beneficiary falls out of favour.

Under the discretionary trust, no beneficiary has a right to either income or capital. The trustees are able to appoint income or capital at their discretion to any beneficiary within the class of potential beneficiaries named in the trust deed.

The settlor(s) are generally automatically included as trustees. The settlor(s) should also appoint at least one additional trustee to ensure the validity of the loan agreement. The appointment of additional trustees also avoids the need to appoint replacement trustees after the settlor(s) death.

Establishing the loan

A loan agreement is set up between the settlor and the trustees. Clearly this can only take place after the trust has been created and the trustees have been appointed. It's not possible to lend money to yourself so it's important that the lender and borrower are not the same person, otherwise the loan may not be valid. To ensure the borrower is different from the lender, trustees in addition to the settlor must be appointed at outset.

The amount loaned to the trustees is cash amount and cannot usually be a loan of an existing asset. No interest is charged on the loan and it is repayable on demand either in full or in part.

Setting up the investment

The trustees invest the amount loaned to them, typically into an investment bond. There are a number of advantages of using a bond:

• Bonds are non-incoming producing assets. This means there no tax upon the trustees and income doesn’t need to be paid to any beneficiaries who may have a right to income under the trust
• There's generally no tax reporting for the trustees until there is a chargeable gain (for example, when the bond or segments are surrendered or withdrawals in excess of the 5% allowance are taken)
• The 5% withdrawal facility allows regular loan repayments to be made to the settlor without an immediate tax charge

IHT on the creation of a loan trust

There's no transfer of value for IHT when the loan trust is set up as the settlor loans the money to the trustees rather than gifting it. Therefore there's no PET or CLT on creation.

There's no Gift with Reservation (GWR) provided the settlor’s access is restricted to the repayment of the outstanding loan and they can't benefit from the trust.

Lifetime of the settlor

Repaying the loan

The settlor can demand repayment of the loan at any time. As the amount of the outstanding loan diminishes as it is repaid; so too will the value of what is included in the estate.

Once the loan has been fully repaid the settlor can no longer benefit. It's important that loan repayments are monitored because if more than the amount loaned to the trustees is taken, it could lead to a gift with reservation and bring the entire trust value back into the estate.

Typically the trust wording excludes the trustees from being personally responsible if the assets have fallen in value and the loan cannot be repaid. However, the trustees will need to remember that making appointments to beneficiaries could affect their ability to repay the loan and they may be responsible for any shortfall. Generally appointments to beneficiaries should only be considered once the loan has been repaid or, at the very least, once there will be sufficient funds remaining in the trust after the appointment to cover the outstanding loan.

Chargeable gains may arise when the loan is repaid to the settlor if the bond (or segments) is surrendered or withdrawals exceed the cumulative 5% allowance. Any gains will be assessed upon the settlor except for absolute loan trusts where the trust is looked through and gains assessed upon the beneficiaries.

Assigning segments to the settlor to satisfy the outstanding loan will be treated as an assignment for money or money’s worth. This will give rise to an immediate chargeable event.

Normally a part surrender gain is taxed at the end of the policy year based on the ownership at that time. There are special rules that apply where a part surrender chargeable gain is followed by an assignment. To ensure that tax falls on the right person, the part surrender chargeable event is treated as occurring when it happens rather than at the end of the policy year.

Trust IHT charges

Flexible and discretionary trust loan trusts are subject to IHT relevant property charges.

There will be a periodic charge at each 10^th anniversary. The value of the loan trust after deduction of the outstanding loan is used to calculate any periodic charge. Broadly speaking there will be a 6% charge on the value above the available nil rate band.

However, the trustees must complete an IHT100 form if the value of trust without deduction of the loan exceeds 80% of the nil rate band.

There is no IHT exit charge when loan repayments are made to the settlor.

Exit charges may apply when capital is appointed to a beneficiary. There will be no charge on exits made in the first 10 years as there will be no IHT payable when the trust is created.

Giving up the loan

If the settlor no longer needs access to the outstanding loan they can give up the right to some or all of it. There are two options for giving away the right to the loan;

1. Waive the right to the loan. Here the settlor gives up the right the loan in favour of the trust. As the trustees no longer have to repay the loan, all the assets are now held for the beneficiaries.
   
   This will be a transfer of value for IHT. For an absolute trust this will be a PET and for Flexible and Discretionary Trusts it will be a CLT.
2. Give the right to the loan to another person. The right to the loan repayments can be given away, for example to a spouse or their children, allowing the recipient to have exactly the same right to recall the outstanding loan.
   
   This will generally be a PET regardless of the type of underlying trust. Gifts of the loan to a spouse or civil partner will be covered by the spousal exemption.
   
   Any chargeable gains which arise on repayment of the loan for flexible and discretionary trusts will continue to be assessed upon the settlor.

Death of the settlor

The trust doesn’t come to an end up on the settlor’s death. The trust will remain until such time as the trustees have appointed all the assets out to the beneficiaries.

On the death of the settlor, any outstanding loan from a loan trust will be an asset of the settlor's estate and therefore potentially subject to inheritance tax.

Loan repayment options

If the outstanding loan is not specifically dealt with in the lender’s Will, it forms part of the residue of the estate. This will normally mean that the trustees will need to repay the outstanding loan to the estate and some or all of the bond will be surrendered. Any value in excess of the loan continues to be held on trust for the beneficiaries.

Alternatively, there are a number of options for dealing with the outstanding loan on death which can be included within the settlor’s Will.

• Leave it 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. 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.

Waiving or gifting the loan in this way avoids the need to surrender the investment bond on the settlor’s death.

Dealing with the investment bond

Often the bond is set up with additional lives assured and will continue after the settlor’s death. The bond (or segments) may need to be surrendered by the trustees to repay the loan.

The assessment of any chargeable gain when the trustees surrender the bond will depend upon the type of trust and also the timing of the surrender.

• Any chargeable gains on absolute loan trust will be assessed against the beneficiary
• For flexible and discretionary loan trusts any gains will be assessed on:
  • the settlor, if surrender in the tax year of the settlor’s death or
  • the trustees at 45%, if the surrender takes place in a subsequent tax year

Assigning segments to satisfy the outstanding loan will be treated as an assignment for money or money’s worth. This will give rise to an immediate chargeable event.

If the settlor’s will waives the right to the loan on death, the trustees are free from debt and are able to assign to beneficiaries without creating a chargeable event. 

Where the settlor was the last life assured, the bond will come to an end and a chargeable gain will arise and be assessed upon the settlor in the tax year of their death. The trustees will have the capital to repay any outstanding loan to the estate. The balance after repayment of the loan is held for the beneficiaries. The trustees can either distribute the remaining capital to the beneficiaries or reinvest within the trust for distribution at a later date.