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Loan Trusts

18/06/2024

Inheritance Tax

The inheritance tax (IHT) nil-rate band of £325,000 has been frozen since 6 April 2009. Since that time, the tax it raises has more than tripled (to over £7.5bn in 2023/24).

Alongside the residence nil-rate band of £175,000, IHT thresholds are currently set to remain frozen until at least 5 April 2028. This means the tax raised by IHT is forecast to continue to rise rapidly. 

Neither of the main parties have made any pledges to increase IHT thresholds. Instead, with both Labour and the Conservatives stating that they won’t increase other taxes, there is a possibility that the next Government may look to further increase the tax raised from IHT to fund any budget shortfalls. 

With more and more people’s estates subject to taxation, there is increasing demand for ways to reduce or eliminate the charge. One way to do this is by using a Loan Trust. This helps to freeze the size of someone’s estate and increases the amount that can be passed on to loved ones. 

How a Loan Trust works

A trust is set up, either with a nominal amount (say £10) or just a simple promise to loan the trustees some money. The settlor then makes the loan to the trustees, which is interest free, but repayable on demand. The loan is then invested, usually within a life assurance investment bond. 

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

The settlor can request repayment of the loan as and when they require access to the capital. Assuming the loan is invested in a bond, the trustees can withdraw up to 5% of the investment each year without an immediate liability to tax - These tax deferred withdrawals can be used to make repayments of the loan as and when the settlor requires. 

Note that the 5% tax deferred withdrawal allowance is cumulative. This means that if unused, it can be carried forward to future years. As the unused allowance isn’t lost, there is more flexibility to allow the investment time to grow before any repayments start. 

Benefits of a Loan Trust

The main benefit of using a Loan Trust is to reduce or eliminate any future charge to inheritance tax, whilst still giving the settlor access to their capital when they need it. A Loan Trust allows for:

  • large amounts to be placed into trust without creating an immediate tax liability – a loan does not create a chargeable lifetime transfer (CLT) or potentially exempt transfer (PET).
  • repayments of the loan to be used as a regular (tax deferred) income for the settlor.
  • full access for the settlor to their money - they can request repayment of the loan at any time. 
  • the ability for the settlor to write off all or part of the loan at any point, reducing their taxable estate for IHT further – a useful way to use the £3,000 annual exemption for gifts each year. 
  • loan repayments to be used for general spending needs, further reducing the settlor’s chargeable estate for IHT.
  • the settlor to be a trustee, granting them a high degree of control over who will eventually benefit from the funds and at what point.

Case study – Albert

Albert (70) sets up a trust and makes an interest free loan to the trustees of £250,000. This is invested in a bond that returns 5% a year, after all charges. 

At the end of each year, Albert will ask for a loan repayment of £12,500, which the trustees will repay using the 5% tax deferred allowance. Albert also intends to write off a further £3,000 each year (utilising his inheritance tax annual gift exemption).

After 5 years, Albert decides that he no longer needs £12,500 a year, so reduces the loan repayments to £5,000 a year. He continues to write off £3,000 each year using his annual gift allowance.

After 10 years, Albert decides to pay for a luxury family holiday to celebrate his 80th birthday. To do this, he requests an additional repayment of £20,000 (£25,000 in total)*. 

* Since the Trustees have only drawn £5,000 of the annual £12,500 (5%) tax deferred allowance over the prior 4 years, up to £42,500 (£12,500 + (£7,500 x 4) can be taken without any immediate tax liability. This means that the £25,000 payment does not result in a chargeable event. 

At age 90 Albert dies. At this point, the bond is worth £379,261, of which £32,500 is the remainder of the outstanding loan and is repayable to Albert’s estate. The remaining £346,761 is outside his estate and is therefore not assessable for inheritance tax, as illustrated below: 

Graph showing Amount Outside Estate steadily increasing from £250,000 to around £375,000 and Loan decreasing from £250,000 to below £50,000 over 20 years .

Comment

Loan Trusts can provide a very useful tool for estate planning. With the recent rise in the discount rate used for Discounted Gift Trusts (DGT’s), advisers have been increasingly looking at Loan Trusts as an alternative, more flexible way of tackling IHT. However, consideration is needed as to what will happen to the loan when death occurs before it has been fully repaid.

When setting up a Loan Trust, the settlor should consider updating their Will at the same time to gift any outstanding loan to either an individual or the trustees. If this is not covered, the loan will normally need to be repaid on death, meaning the trustees may have to encash the bond. This could unnecessarily cause an income tax liability.

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.