Understanding Loan Trusts
Loan trust schemes give investors access to their original investment whilst achieving a long-term inheritance tax benefit. Loan trusts are most likely to be tested in the CII R06, J02, AF1 or AF5 exams.
The Process of Setting Up a Loan Trust
The process of setting up a loan trust is quite straightforward, but everything needs to be done in the correct order to be effective.
- Firstly, the settlor sets up a trust (usually a discretionary trust) and appoints trustees.
- Next, the settlor makes an interest-free loan to the trustees.
- Finally, the trustees invest this into an investment bond (although it could be a collective investment such as a unit trust or OEIC).
Paying Back the Loan
The trustees can use the 5% withdrawal facility of the investment bond to pay back the original loan to the settlor, thereby creating a tax-efficient ‘income’ for them. More than 5% could be taken from the bond, but this may lead to income tax complications for the settlor as taking more than 5% would be a chargeable event.
The initial loan is repayable on demand, so the settlor has the peace of mind that should they need the capital back, they can ask the trustees to repay any outstanding loan and the trustees must comply.Loan trusts are most likely to appear on the CII R06, J02, AF1, or AF5 exams. Read up on them here. Click To Tweet
Because the initial transfer is a loan and not a gift, there is no transfer of value for IHT purposes.
As the investment bond is held within the trust, any growth is outside the settlor’s estate and is held for the ultimate beneficiaries.
If at the point of the settlor’s death there is an outstanding loan amount, this will be repaid and will then form part of the settlor’s estate for IHT purposes.
While a discretionary trust is generally used, loan repayments do not incur an IHT exit charge. At the point of the 10-year periodic charge, any outstanding loan is deducted from the value of the trust.
The benefits of loan trusts include:
- any future growth on the bond is outside of the settlor’s estate for IHT purposes because it takes place in the trust;
- because the loan is repayable on demand, if the settlor’s circumstances change and they find they need their money back, they can ask the trustees to pay it back; and
- if the settlor spends all of the withdrawals, then his estate is not increased by the return of the capital and they benefit from a regular income.
The potential downsides include:
- the loan is a debt on the settlor’s estate and must be paid back on their death:
- if this is relatively soon after making the loan, there will be very little in the way of IHT saved.
- if, on the other hand, death doesn’t occur until after twenty years and all of the withdrawals have been made, the settlor’s income stream stops.
- The settlor cannot access any remaining capital in the investment bond because this now belongs to the trust.
In summary, the maximum IHT benefit from a loan trust comes after the loan has been fully repaid. This will be after 20 years if 5% has been repaid annually. However, once the loan has been repaid, the settlor has no further access to the trust fund.
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