Techzone

Many clients are being forced to consider estate planning much sooner than they anticipated with pension death benefits becoming subject to IHT. The 6 April 2027 might be the day that many estates are brought into the IHT net for the very first time. It will dramatically reduce the average age for estates with a potential IHT liability.

But not everybody will be ready to give away assets to bring the value of the estate down. For those clients a loan trust could be the first tentative step on the estate planning journey - one which allows them to retain access to their original capital but keeps the investment growth outside the estate, effectively capping their liability. Further down the line, if they no longer require access to the loan, it can be given away when they feel they’re ready to make gifts.

Loan Trusts – the basics

At its simplest level, a client may be aware of the potential for IHT on their death, but may not currently be able to afford to make a lifetime gift of capital because:

• they need the capital to support their annual income and/or
• they may need access to the capital on an ad hoc basis in the future.

Loan trusts can provide for these circumstances. Instead of gifting cash to trustees, cash is transferred to the trustees under the terms of a loan. As the rights to the loan is still an asset of the estate, the value of the estate immediately after making the loan has not changed. There has been no transfer of value. The IHT savings made are on the future growth on the investment made by trustees, typically an investment bond. Any growth is outside the estate immediately – the client is effectively capping their IHT liability.

Using loan trusts with gift trusts

It isn’t just clients who are unsure about making lifetime gifts who should consider a loan trust. At the other end of the scale, a client may wish to make a gift of more than their available nil rate band but don't want to pay any lifetime IHT and want to retain control as trustee.

One solution is to partner the loan trust with a gift trust. A gift is made to the trust up to the client’s available nil rate band, and a loan is made to a separate loan trust. This will avoid any immediate IHT.

Using loan trusts with discounted gift trusts

Discounted gift trusts allow gifts to be made subject to a retained interest in the form of fixed regular payments to the settlor. The amount of regular payments is chosen at outset and a discount is applied to the gift for IHT reflecting the retained payments and the  settlor’s life expectancy.

For example, £500,000 could be gifted to a discretionary trust and invested in a bond, but if the discount is £175,000, the value transferred for IHT would fall within the full nil rate band of £325,000 and avoid an immediate lifetime IHT. Future growth on the investment is outside the estate immediately.

This works well for someone who needs a regular ‘income’ from their capital while at the same time making a gift for IHT. The income must be spent otherwise it will accumulate in the estate and ultimately inflate the potential IHT bill.

Discounted gift trusts don't generally allow the settlor to increase their regular payments or take ad hoc lump sums. If clients think they may need to access larger amounts later, or wish to increase their regular payments to reduce the impact of inflation, consideration could be given to dovetailing the discounted gift trust with a loan trust. Loan repayments could be taken from the loan trust as and when required, supplementing the regular fixed payments from the discounted gift trust.

Putting multiple trusts in the right order

Where a loan trust is to be paired with a discretionary gift trust or discounted gift trust, setting up the trusts in the right order can reduce the relevant property charges on the 10-year anniversaries and on distributions to beneficiaries.

The key to this is that there is no transfer of value when the loan is made to a loan trust. Gifts into discretionary trusts are chargeable lifetime transfers, and the trusts themselves are subject to a ‘periodic’ or ‘principal charge on each 10th anniversary. Each discretionary trust will have its own nil rate band, but this is reduced by the chargeable transfers made by the settlor in the seven years prior to the trust start date.

So, if a discretionary gift trust is created with a transfer of £325,000 followed the next day by a discretionary loan trust, both trusts will be subject to a periodic charge, but only the gift trust will have the full nil rate band. The nil rate band available to the loan trust is reduced by the earlier transfer to the gift trust – this means that if the nil rate band remains the same in 10 years’ time, the loan trust will have no nil rate band available and all the growth would be taxable at 6%.

It is therefore good planning to set up the loan plan first – this way both trusts will have the full nil rate band available at the 10-year anniversary.

Dealing with the loan during lifetime

A client’s circumstances may change over time. The need to retain access the loan capital may be important at the time the loan trust is set up, but that priority may change and access may no longer be required. In this scenario the loan can either be ‘gifted’ in part or in full, depending on the provider’s conditions.

Gifting the loan to a discretionary loan trust will be a chargeable lifetime transfer (CLT) and clients need to be careful that their cumulative CLTs in the last seven years do not exceed their nil rate band resulting in a lifetime charge to IHT.

Where the loan is no longer needed, another option would be to gift the rights to the outstanding loan to another individual. This would be classed as a potentially exempt transfer and would not incur a lifetime IHT charge, but if it becomes failed PET, then it will be added to other CLTs in the seven years prior to death and could retrospectively suffer an IHT charge.

Dealing with the loan on death

The outstanding loan is always an asset of the estate and potentially subject to IHT on death.

It is crucial to consider what happens to the loan on death. There are two main options:

1. Leave the outstanding loan to a beneficiary of the estate
2. Waive the loan to the loan trust

Both can be achieved by making provisions in the client’s Will.

The rights to the outstanding loan can be left to another individual. If left to a spouse or civil partner, the spouse exemption will apply and there will be no IHT.

Provisions can also be made in the Will for the loan to be gifted or ‘waived’ to the trust. Some providers will include this as an option on the trust application at outset.

Although the value waived is still included in the estate of the deceased settlor for IHT, waiving the loan can simplify the future management of the trust for the trustees allowing them to control which beneficiaries benefit and when, without having to consider a loan.

Summary

The introduction of IHT on pensions will mean a greater number of clients will be seeking estate planning and at earlier ages. A loan trust is great introduction to estate planning and one that is flexible enough to adapt financial plans as circumstances change.