Strong investment returns, frozen allowances and further rises to Inheritance Tax (IHT) has meant some individuals now wish to revisit past estate planning. Indeed, some individuals who thought they had put their estates in order will now find their loved ones are again facing a large tax bill after they die.

For many, loan trusts will provide the appropriate solution. They can be particularly beneficial for those who have already set up trusts in the last seven years.

Case study - Bernard

Bernard (75) is a wealthy widower, with a long-term partner and three children from his past marriage. 5 years ago, he conducted some estate planning and decided to put £600,000 in a Discounted Gift Trust (DGT) for the benefit of his partner and children.

The DGT provides Bernard with an income for life of £25,000 per year and after the discount, the gift to the trust resulted a Chargeable Lifetime Transfer (CLT) of £300,000. This met Bernard’s needs in that it:

• Provided Bernard with an income in retirement.
• Ensured that the trust could continue to provide for his partner in her lifetime, but would ultimately benefit his children and grandchildren.
• Eliminated much of the potential inheritance tax bill that would arise on his death.

Since then, Bernard has seen the value of his property and other investments increase. This has coincided with various Government announcements that have widened the IHT net and frozen IHT thresholds for the considerable future.

Bernard is concerned that he is once again facing a large IHT liability and contacts his adviser.

Planning obstacles

Bernard’s adviser explains that there are some potential complications for Bernard if he were to make further gifts. For instance:

• The £25,000 received from the DGT each year is treated by HMRC as a return of capital. This means that he does not have sufficient income to make regular gifts that could qualify under the normal expenditure out of income IHT exemption.
• Any gift exceeding the £3,000 annual gift exemption will be treated as either a Potentially Exempt Transfer (PET) or a further Chargeable Lifetime Transfer (CLT).
• A further CLT or PET made in the next two years would result in the £300,000 CLT made 5 years ago remaining in his estate for a further 7 years – known as the ‘14 year rule’.* 
• As a CLT of £300,000 was made in the last 7 years, Bernard currently has only £25,000 of his £325,000 nil rate band remaining.
• This means that a further gift into trust (classed as a CLT) will be subject to an immediate IHT charge of 20% (half the death rate) on any amount exceeding £25,000.

* The ‘14 year rule’ is where a second CLT or PET is made in the seven years following the first CLT. On subsequent death within seven years of the new gift, the earlier CLT continues to use up any available nil-rate band (i.e. for up to a maximum of 14 years).

Next steps

Bernard’s adviser explains that it would be beneficial to wait two years before making further large gifts, as this will allow the CLT made 5 years ago to fully drop out of his estate. However, he can use loan trusts now to immediately freeze his IHT liability and allow him to make tax efficient gifts later on.

A loan trust involves setting up a trust and then making a loan to the trustees, which is interest free and repayable on demand. The loan is then invested, usually within a life assurance investment bond.

The loan will remain in Bernard’s estate for IHT purposes. However, any growth on the investment will be outside his estate and will be for the benefit of the trust’s beneficiaries.

Benefits of this approach

Loan trusts will provide Bernard with several advantages. For instance:

• Bernard retains access to his capital and control over how the investment benefits both his partner and children/grandchildren in future.
• Any future growth in the trust will immediately be outside Bernard’s estate.
• Unlike his DGT, the loan trust does not create an income stream (back into his estate), and he will only request loan repayments if they are needed.
• As the loan does not constitute a gift, the CLT made 5 years ago will still be fully outside his estate in two years – the ‘14-year rule’ will not apply.
• Bernard can use his annual gift exemption to write off up to £3,000 of the loan each year (starting immediately if he so chooses).
• In 2 years’ time, the CLT made 5 years ago will drop out of his estate. He will then have full flexibility to write off a larger amount of the loan as either:
  
  
  • A CLT - by writing off part of the loan as a gift to the trust.
  • A PET – by gifting some of the loan to his partner or children, who can then request repayment from the trustees.
• Bernard can also use a series of smaller loan trusts (created on separate days so they aren’t related settlements). Each will then benefit from its own nil rate band of £25,000 (Bernard’s remaining amount), which greatly reduces the chances of incurring a 10 yearly periodic or exit charge later on.*

* A trust’s nil rate band for calculating 10 yearly periodic and exit charges is based on the settlor’s available nil rate band when the trust was set up. As a loan trust involves no gift (CLT), a series of loan trusts won’t reduce the amount available for each one – known as the ‘Rysaffe principle’, after the case of ‘Rysaffe Trustee Co (CI) v Inland Revenue Commissioners 2003’.

Comment

Increasingly, advisers and their clients are considering loan trusts as a great way to navigate IHT. They can be especially useful where a client has previously used trusts and made CLTs in the last 7 years.

Investment bonds are particularly suited as trustee investments since they allow 5% tax deferred withdrawals, do not produce income and are not subject to Capital Gains Tax (CGT). 

Bonds have become more relevant for most trusts following changes to CGT and freezes in income tax bands. Trustees now only have a CGT allowance of £1,500, meaning that even simple rebalancing via a Managed Portfolio Service (MPS), can now result in trustees incurring a CGT charge when investing through a General Investment Account (GIA).

Important information

Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.