The gift and loan trust, or sometimes simply a loan trust, is a very popular weapon in the professional adviser’s armoury and one that can help clients reduce their inheritance tax (IHT).
It allows clients full access to their capital, to ease the worry of unforeseen circumstances, whilst preventing the potential IHT liability on the capital increasing.
It is IHT neutral at outset as the asset of the trust (apart from the initial gift of £10) is the loan. Since it is repayable on demand, the loan to the trustees is not a transfer of value (and so does not impact on subsequent arrangements). However, if the trust is discretionary there may be potential periodic and exit charges if the growth exceeds the nil rate band available to the trust.
For large loans, it may be beneficial to spread the amount over multiple gift and loan trusts created on different days.
If there have been no transfers of value in the seven years before commencement, a discretionary loan trust will have a full nil rate band available to it on each tenth anniversary, providing that there were no additional arrangements set up on the same day. Therefore, having two or more gift and loan trusts set up on consecutive days would allow the trustees of each to potentially have a full nil rate band for each trust, thereby reducing the possibility of a periodic charge.
John and Moira
Like a lot of people John and Moira don’t like paying tax and are determined that Her Majesty’s Revenue & Customs not get more than their fair share after they are gone. John and Moira would rather their family inherited their wealth rather than the taxman. They hope that this is many years away and, as they are approaching retirement, they want to ‘keep their options open’.
After discussions with their professional adviser, John and Moira like the idea of combining IHT savings with full access to the initial capital; as John says, “you never know if we will need this capital to fund retirement or long term care”. So, their professional adviser recommends that they lend £600,000 (jointly) to the trustees of a discretionary trust under which their family are the beneficiaries.
So to begin they set up a discretionary gift and loan trust with a £10 gift, which is handed to the trustees. This £10 gift establishes the effective date of the trust.
The adviser explains that, under the trust, they are automatically trustees but, as they are both lending money to the trust, another person needs to be appointed.
John and Moira choose a discretionary trust, as opposed to a bare trust, in case the trustees decide at a later date to pass money onto grandchildren or others. Although it is more complex from an IHT perspective, they prefer the flexibility to change beneficiaries.
This will avoid problems if a beneficiary dies before they do, or if an intended beneficiary becomes bankrupt, gets divorced or falls out with their parents. As they may not be around at that time, on the adviser’s suggestion they draw up a short letter of wishes ‘to whom it may concern’. This states that the main beneficiaries are to be their children, but consideration should be given to retaining some of the trust fund for the education of any grandchildren and great-grandchildren.
They decide to ask Moira’s younger brother, Stewart, and John’s sister, Meg, if they would be co-trustees and they agree to this.
Once the trust has been set up, John and Moira each make a loan of £300,000 to the trustees (themselves, Stewart and Meg). The loans are made independently from each other from their sole bank accounts. There is a loan agreement completed by each of them, between the lender and the trustees. The intention is that the trustees will then invest the loan.
As trustees John, Moira and Stewart invest the loan in an investment bond under which growth will accrue to the beneficiaries free from IHT.
John and Moira, having other income, do not require access to their loan. However, in year seven they have both fully retired and need to supplement their pension income. John and Moira ask their adviser how they can access their capital. Assuming a 5% growth rate, the bond has grown to £844,260.30 and John and Moira are pleased to find out that the £244,260.30 growth is outside their estate, saving £97,704.12 in IHT.
The adviser then explains that the trustees can withdraw an amount each year from the bond and pay this to John and Moira as loan repayments. Each year normally the trustees can only withdraw between 0% and 5% deferring any income tax liability as a chargeable event will not occur. This is because 5% of the total amount invested each year can be withdrawn without an immediate liability to income tax. This is known as the ‘tax-deferred withdrawal’ facility.
However, their adviser explains that he said “normally” because where the tax-deferred withdrawal facility is not used in any one year, it can be carried over to the next year, so currently the trustees could potentially withdraw up to 35% without a chargeable event occurring.
With the help of their adviser, John and Moira decide that they require £36,000 each year to supplement their pension income and ask the trustees to start regular yearly withdrawals from the bond. This equates to 6% of the original investment but will not trigger a chargeable event due to the cumulative tax-deferred allowance. Actually, John and Moira can have the whole loan repaid over the next 16 years without incurring a chargeable event.
What happens to their outstanding loans if something happens to one of them? The adviser explains that on death any outstanding balance of their loan forms part of their estate and would potentially be subject to IHT. However, if their wills include an appropriate clause or a codicil is attached, loan repayments could continue to the survivor or to someone else.
Or they could just include a clause in the will instructing their executors to forego the loan and leave the balance in the trust as a gift (this would be a chargeable transfer by their estate).
What has been achieved?
By capping the IHT liability to the original capital, John and Moira have been able to:
- flexibly access their capital as and when they need it, and
- mitigate IHT by having all the growth on the investment outside their estate.
They also have the option to vary or stop the loan repayments they receive, as well as having the ability to waive full entitlement to the outstanding loan at any time by means of a chargeable transfer, either during lifetime or on death.
A discretionary trust ensures that the trust assets won’t form part of the beneficiaries’ estates.
However, clients should be aware that:
- on their death the remaining loan value will form part oftheir estate;
- they cannot get back more than the original loan;
- if the trustees withdraw more than the cumulative tax-deferred allowance, a chargeable event will occur and they may be liable to income tax.
A combination of IHT solutions may be appropriate but one point this article highlights is that the family benefitted from the help of a professional adviser throughout, to ensure that they made the correct choices.