Helen O’Hagan, Technical Manager at Prudential looks at loan trusts – helping to make the trust journey simpler and less complex.
W – why use a loan trust
H – how to use a loan trust
A – access for the settlor and beneficiaries
T – taxation of the trust
WHY use a loan trust?
Loan trusts are for clients who want to do inheritance tax (IHT) planning but can’t quite give up access to their capital. Using a loan trust allows clients access to their original capital at any point and in any amount but the growth will not be included in their estate for IHT purposes. A typical scenario is where this is the client’s first introduction to IHT planning. They may not like the idea of giving away, outright, all of their nest egg, so using a loan trust allows them to retain control and gives them access to their capital.
Normally there are two types available – absolute loan trusts and discretionary loan trusts.
With a loan trust, the loan can be waived in part or in full at any time. This is an excellent opportunity to suggest to clients that they use their IHT annual exemption and waive £3,000pa or £6,000pa in a joint settlor trust. By waiving small amounts at a time allows them to gently give up access to their capital.
HOW do you set up a loan trust?
A loan trust normally has to be set up with new monies – you cannot normally use an existing bond to create a loan trust. The settlor lends monies to the trustees who in turn buy the bond. It is very important to get the order correct when you are setting up a loan trust. The trust has to be created first and then the trustees buy the bond. It is acceptable to have the date of the trust and the date on the application form dated on the same day as the assumption is the trust was dated in the morning and the application in the afternoon. It is not acceptable to have the bonds dated before the trust deed as you cannot set up a bond with trustees who do not exist yet.
You can top up an existing loan trust – the settlor can do this by either way of a further loan or by way of a gift.
ACCESS for the settlor and beneficiaries
What access do the settlors and the beneficiaries have to the trust fund? The settlor has full access to any outstanding loan and NOTHING else. The loan is interest free and repayable on demand. In a joint settlor case the right to repayment of the loan will automatically pass to the survivor. All of the growth and any amounts waived must be held for the benefit of the beneficiaries and therefore the settlors have absolutely no access to the trust fund whatsoever – you will normally find a settlor’s exclusion clause within the deed along these lines:
5. Settlor exclusion clause
(1) The Trust Fund shall be possessed and enjoyed to the entire exclusion of the Settlor and of any benefit to him by contract or otherwise and no provision of this Settlement and no discretion or power shall operate so as to allow any of the capital or income of the Trust Fund to become payable to or applicable for the benefit of the Settlor in any circumstances whatsoever.
In respect of the beneficiaries, this depends on whether it is an absolute trust or a discretionary trust that has been chosen.
Under an absolute trust, the beneficiaries can demand the trust fund once they reach age 18 (16 if written under Scots law) and the trustees are legally obliged to inform the beneficiary that the trust fund exists. The trust fund will form part of the beneficiary’s estate for divorce, bankruptcy and for inheritance tax. If an absolute beneficiary dies, the trustees have to look at the will or follow intestacy rules to see who will now benefit.
Under a discretionary trust, it’s up to the trustees to decide who will benefit and when they will benefit from the trust fund. As long as the beneficiary is in the class of beneficiaries, the trustees can allocate funds to them. This is why clients should choose their trustees wisely as ultimately they will be dealing with the trust fund. It is advisable for clients to lodge a letter of wishes with the trustees to give them some guidance, after their death, as to how they want the trust fund divided up. Remember that a discretionary beneficiary cannot demand monies from the trustees nor does this form part of their estate for divorce, bankruptcy or inheritance tax while inside the trust.
There is no entitlement to the outstanding loan by the beneficiaries.
TAXATION of the trust
What IHT is payable on a loan trust? There is NO transfer of value when you set up a loan trust; there is no gift just a loan.
Any amounts waived which are not exempt will either be a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT) depending on whether an absolute trust or a discretionary trust has been chosen.
Under an absolute trust, the amount waived (if not exempt) creates a PET, which after seven years from the date of the deed of waiver becomes exempt from inheritance tax. If the settlor dies within the seven years, the PET becomes chargeable.
Under a discretionary trust, the amount waived creates a CLT, which may attract an entry charge if the value of the waived amount when added to any other CLTs made in the previous seven years exceeds the settlor’s current nil rate band. Again CLTs drop out after seven years as long as no PETs are created after the CLT. If a settlor creates a mixture of PETs and CLTs this can lead to a 14 year timeline. If a PET fails and becomes chargeable, it pulls in any CLTs made within seven years of the failed PET, thus potentially going back 14 years.
Discretionary trusts may also be subject to periodic charges every ten years and exit charges which are explained in our Estate Planning Guide on our website. Bear in mind, however, in the case of a loan trust that the assessable amount would be the bond value less the outstanding loan.
Remember that gifts, i.e. PETs and CLTs, eat into the nil rate band in chronological order; thus when calculating any IHT liability, they will be applied first against the nil rate band.
Don’t forget that any top ups by gift will be either PETs or CLTs from the date of the top up.
Any outstanding loan forms part of the settlor’s estate for IHT purposes.
As you can see, trusts don’t have to be complex nor convoluted. Our Technical Helpline will be more than happy to answer any questions that you have. You will find more details of the taxation of discretionary trusts in our Adviser Guide to Estate Planning
And, finally, if you want details of how bonds are taxed within a trust see our Technical Centre.