Using loan trusts to save IHT
A loan trust can be used as a vehicle to save inheritance tax, whilst retaining the ability to access the funds lent to the trust.
How does it work?
There are two elements to setting up a loan trust – the loan and the trust.
A trust is set up, which can be an absolute trust or a discretionary trust, and trustees are appointed. The settlor can also be a trustee.
Where an absolute trust is used, the beneficiaries and their share of the fund must be specified when the trust is created. A discretionary trust provides the flexibility to change the beneficiaries and their share – although there may be tax to pay.
The settlor makes a loan to the trust. The loan is invested in an investment bond with the potential for growth. The original loan is repayable, usually in regular instalments. In this way, the settlor is able to get back their loan capital. Equally, the settlor could choose for the loan not be repaid or repaid in full or in part at any time.
The settlor does not have access to the income that builds up in the trust. This is passed to the beneficiaries.
Any part of the original loan that remains in the trust at the time of the settlor’s death forms part of the settlor’s estate. This is because the settlor has retained access to the money.
However, income from the investment does not form part of the estate – although if the trust is a discretionary trust tax may be paid by the trust on the 10-year anniversary and when money leaves the trust.
Oscar created a discretionary loan trust and appoints his twin daughters as beneficiaries. He lends £100,000 to the trust.
The loan is repaid to Oscar at the rate of £5,000 a year.
Oscar dies five years and seven months later. At the date of his death, he had received loan repayments of £25,000.
The value of the trust at the date of his death was £124,000.
At the date of death, £75,000 of the original loan remained in his estate. The remaining £49,000 represents income growth and does not form part of his estate and can be passed to the beneficiaries free from inheritance tax.
As the settlor retains access to the funds lent to the trust, they remain in his or her estate. To take the funds out of the estate, the settlor would have to give them away absolutely. If in the above example, Oscar had not needed to retain access to the funds, he could have passed them on to his daughter when he was alive and benefited from taper relief having survived for five years.
The loan trust is something of a half-way house – the settlor has the comfort of being able to access the loan capital, but any growth is taken out of the estate.