Case study: When to use a loan trust for inheritance tax planning

Brown, Gerry_700x450

Pierre, age 61, has recently retired from his role as conductor of the Ambridge Symphony Orchestra. He has a portfolio of Oeics, yielding about £3,000 annually, and is accordingly looking forward to the introduction of the “new” dividend tax regime. Early last year Pierre sold a barn conversion he inherited from his late wife. The sale realised £400,000 and the capital gains tax of £40,000 was paid in January this year.

Pierre is keen to undertake some inheritance tax planning but does not want to make substantial gifts at the current time as he is concerned about a future need to pay for long-term care.

The solution

Pierre consults his adviser who suggests his objectives could be achieved by using a loan trust, which is structured to meet the needs of individuals who wish to undertake IHT planning but for whatever reason feel unable to make substantial outright gifts.

Pierre wants the trust fund to be used to provide assistance with educational expenses and musical tuition for his four grandchildren: Adele, Brian, Corinne and Daniel.

In a loan trust arrangement the original loan value is held for the benefit of the settlor, while the growth is held for the benefit of the beneficiaries. The settlor is not a beneficiary and cannot benefit in any way other than through repayment of the loan.

Pierre set  up a loan trust on 1 March with a loan of £300,000, which is immediately invested in a life assurance bond with 20 segments.

In loan trusts the settlor’s loan is usually repaid in an income tax efficient way using the 5 per cent tax deferred withdrawal facility available with a life assurance bond.

Pierre is the settlor and his children, Benjamin and William, act as trustees. Benjamin and William are the “lives assured” on the bond.

The loan trust established by Pierre is discretionary in structure so it can accommodate future changes in circumstances. Pierre intends the ultimate beneficiaries to be his grandchildren. His adviser helps him to prepare a suitable letter to the trustees setting out his wishes regarding the use of the trust fund.

Long-term planning

Pierre’s adviser then uses a scenario to illustrate how the loan trust might be administered in the future.

By April 2020 the trust fund (effectively the bond) is projected to be worth £350,000.

The trustees have the power to advance capital to any beneficiary and at this point decide to distribute £40,000: £10,000 in respect of each of Pierre’s grandchildren. There is no income tax chargeable event and the money is used to pay school fees.

The settlor may write off all or part of the loan at any time. Unless the trust was “bare” in nature, this write-off would trigger an IHT- chargeable lifetime transfer. If the trust was “bare” the write-off would be a potentially exempt transfer.

In December 2020 the trustees repay Pierre £10,000 to spend on an extended holiday.

In August 2021 the trustees distribute another £40,000 (£10,000 in respect of each of Pierre’s grandchildren) again used to fund school fees.

In October 2021 Pierre decides to write off £50,000 of the loan. He has decided he will not need as much from the arrangement as he previously thought. For IHT purposes this is a chargeable transfer but falls within Pierre’s nil-rate band. This write-off is not an income tax-chargeable event.

When a beneficiary reaches the age of 18 the trustees can assign a bond segment, technically a discrete policy, to him or her. This assignment is not a chargeable event. The assignee could thereafter surrender it as absolute owner. Although this would be a chargeable event, the assignee’s personal tax position would often mean no tax was actually payable.

Pierre’s eldest grandchild, Adele, turns 18 on 1 July 2022. In October 2022 the trustees assign two segments to her and she subsequently surrenders them, one in tax year 2022-2023 and the second in tax year 2023-2024, getting proceeds of £30,000. Although there is a chargeable event gain in both years there is no actual tax liability because of Adele’s tax position. She uses the money to fund her university accommodation and to buy a secondhand car.

In November 2022 the trustees distribute £7,500 (£2,500 each to Brian and Corinne and Daniel). This process is repeated in October 2023.

Pierre gets a further £10,000 repayment of his loan in May 2024. He then writes off £100,000, reducing his loan to £30,000. This is a chargeable lifetime transfer but the availability of his nil rate band means no tax is payable.

By September 2025 all the children are over 18 and in higher education.

The trustees assign two segments to each beneficiary. Each recipient beneficiary encashes these and uses the proceeds to fund living expenses and travelling. Adele graduates shortly thereafter and gets a job.

In September 2026, and again in September 2027, the trustees assign a segment to each of Brian, Corinne and Daniel.

In August 2028 Pierre writes off the remainder of the loan and the trustees distribute the last four segments: one each to Adele, Brian, Corinne and Daniel.

The trustees will have been liable to IHT on each 10th anniversary of the trust’s formation, the first being on 1 March 2026, and transfers to beneficiaries (“exit charges”). As Pierre had made no chargeable transfers in the seven years before the trust was established the trustees will have a full nil-rate band to use on these “events”,  meaning no IHT will be payable. The trust then ends having no remaining assets.

Gerry Brown is a technical manager at Prudential