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Loan trusts are a great way for clients to cap or reduce their IHT liabilities while retaining access to their capital.

They are also an option for those who have made chargeable lifetime transfers up to their nil rate band as there is no transfer of value for IHT and so no charge on entry.

But while the IHT savings are obvious, advice shouldn't stop here.

In particular, extending advice to account for what happens to the loan on death is equally important. Wills should be updated to make sure that the money ends up in the right hands, and so that any untimely tax on bond gains can be avoided.

For example, if the loan is not specifically covered in the will, the executors may have to 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. This could see the trustees paying tax at 45% on the gain if the bond is surrendered in a tax year following the settlor's 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 creating a loan trust to also update their will at the same time to ensure that not only is the outstanding loan dealt with as they intended, but also that their beneficiaries are able to benefit in the most tax efficient way.

The executors will normally call in the outstanding loan unless otherwise instructed. This means the trustees will need to encash some or all of the bond to repay the loan.

Any chargeable gains will be assessed on the deceased settlor if it arises in the tax year in which they died. But if it is delayed until after the tax year end gains will fall upon the trustees at 45%.

If the trustees assign bond segments to repay the loan this will give rise to an immediate chargeable gain. That's because the assignment will be deemed to be for consideration.

This is why it's important to give consideration to how the outstanding loan is dealt with before it is too late.

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. Chargeable event gains may be avoided provided any loan repayments are restricted to making part surrenders from the bond within the 5% tax deferred allowance.
• 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. And again, any loan repayments to the recipient could result in a gain on the bond and a tax charge for the trustees.

Further lifetime planning

While the above actions can prevent an immediate tax charge on the bond, they do not necessarily reduce the client's IHT liability. But reviewing their situation regularly during lifetime could lead to savings here too.

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

Where clients find themselves in this situation, they could make a gift of some or all of the outstanding loan to the trust. 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 the settlor survives the gift by seven years, it will be outside their estate for IHT.

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.

Alternatively, the settlor 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.

However, gifting the outstanding loan to the trust may not be the only answer. For those in retirement with a flexible pension, continued regular loan repayments could be taken instead a pension drawdown income. Pension income could be switched off and protected in an IHT haven, while their IHT liability reduces over time as loan repayments are spent on meeting day to day expenses. This might be particularly useful where the gifting of the whole loan would otherwise result in a lifetime IHT charge.

Summary

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

However, consideration should also be given to what clients want to do with any outstanding loan as this forms part of their estate on death. Doing nothing would leave the outcome in the hands of the executors, which in turn could lead to a chargeable event on the bond should they choose to call in the loan.

More information can be found in our new practical guide, 'Loan trust: options when dealing with the loan'.