Loan plan – overview

A loan plan is a suitable option for clients who wish to mitigate a potential IHT liability but:

• Still need access to capital in the foreseeable future, and/or
• Have already made, or are about to make, lifetime gifts to discretionary trusts and making further such gifts would result in a lifetime IHT tax charge

Broadly, the way it works is that the settlor makes a loan to trustees, i.e. there is no gift, and therefore no transfer of value. The trustees will usually buy an investment bond with the loan, and any future growth will belong to the trust beneficiaries and will be outside the settlor's estate for IHT. The outstanding loan, however, will be included in the settlor's estate for IHT.

While the IHT benefits are clear to see, the consequences of repaying the loan in the future are not always given due consideration. This can lead to issues centred around the fact that money will have to be withdrawn from the bond to repay the loan, and this could give rise to a chargeable event gain and income tax charge which for flexible or discretionary trusts, could be as high as 45% if the gain is assessed on the trust. In this guide, we look at the options for dealing with the loan so that the clients do not suffer an unexpected income tax charge after the death of your client.

Loan options during the settlor's lifetime

Loan repayment to the settlor

Under a loan trust the loan is repayable to the settlor on demand. This means that the settlor can ask for a part or full repayment of the loan at any time.

However, the settlor must not receive any more than their loan back. If they do receive more than they are owed, they could be subject to IHT on all the growth. It could also be regarded as a 'breach of trust' by the trustees with possible legal consequences should any beneficiaries take exception. It is therefore vital that the trustees monitor the loan repayments.

Loan trusts provide considerable flexibility over how and when the loan is repaid to the settlor. It is common for the settlor to set up regular repayments of the loan as a means of supplementing their income. These repayments reduce the outstanding loan, meaning the amount still in the estate reduces (as long as they are spending their withdrawals!).

Of course, the trustees must make the repayments by taking money from the bond, and this could lead to a chargeable event for income tax. However, where this is done by a part surrender (as opposed to a full surrender of segments), then providing each withdrawal is less than the cumulative tax deferred allowance there will be no immediate chargeable event and so no tax charge.

WARNING: remember that if adviser charging is being taken from the bond this will eat into the 5% allowance.

If the settlor requires repayments that exceed the 5% tax deferred allowance the trustees could consider cashing in full segments to repay the loan rather than taking a partial surrender across all segments. Where withdrawals are taken across all segments (i.e. partial withdrawal) any amount in excess of the 5% tax deferred allowance will be a chargeable gain and income tax could be payable.

If instead the trustees surrender full segments, this may produce a smaller gain and lower income tax charge.

Comparisons would need to be done to work out the most tax efficient method of surrender. For discretionary and flexible loan trusts any bond gain will be assessed on the settlor if alive and UK resident. For absolute loan trusts the gain is assessed on the beneficiaries unless they are minor children of the settlor. Top slicing relief is available to both the settlor and beneficiaries as appropriate.

The settlor does not have to take regular loan repayments. Instead, they could take ad hoc repayments as and when required. For example, the settlor may expect to have sufficient income from other sources in the early years but knows that income will reduce in the future. In this situation they take no loan repayments in those earlier years but they have the option to start regular or ad hoc repayments at some point in the future.

Can the loan be repaid by assigning bond segments to the settlor?

Assigning segments to the settlor in repayment of the loan will result in an immediate chargeable event, with any gain taxed on the settlor (or beneficiaries for an absolute loan trust). This is because the assignment is not a gift, but is made to satisfy the settlor's rights to repayment under the loan agreement. As such it is treated as an assignment for 'money or money's worth'.

As there are no tax advantages to repaying the loan by the assignment of segments, the trustees will normally choose to surrender part of the bond themselves so that they can repay loan in cash.

Assignment of segments to distribute capital (growth) to beneficiaries are classed as gift assignments and do not create a chargeable event and any gains on subsequent encashment would be assessed on the beneficiary in the normal way.

Making a gift of the loan

The outstanding loan is an asset of the settlor. Like any other asset, the settlor can choose to gift the loan. This can be done in two ways.

Waiving the right to the loan

If the settlor decides that they no longer need access to their capital they could waive their right to the loan either in full or in part. A deed of waiver would need to be completed. The loan trust provider may offer a draft deed but if not, a solicitor will be able to draw one up.

If the settlor waives their right to the entire loan then the trustees no longer have to repay the loan. This means that the bond is now held for the beneficiaries and the trust has effectively become a gift trust.

Waiving the loan is a 'gift' and will be a transfer of value for IHT. For an absolute trust this will be a potentially exempt transfer (PET) and so there will be no immediate IHT charge. For flexible and discretionary trusts it will be a chargeable lifetime transfer (CLT), and if it is more than their available nil rate band this could mean an immediate IHT charge at the lifetime rate.

If the settlor survives seven years, the gifted loan will be outside their estate and no longer subject to IHT. However, for flexible and discretionary trusts, there is a greater chance of there being an IHT periodic charge or exit charge as the value of the trust will now be the full value of the bond, with no deduction for the loan.

Alternatively, the loan could be waived the in instalments using the IHT annual gift allowance. If no previous gifts have been made, up to £6,000 could be waived in year one followed by up to £3,000 each subsequent year. These amounts would be immediately outside their estate. A deed of waiver is required each time part of the loan is waived.

Gifting the loan to another person

As an alternative to waiving the loan, the settlor could gift the rights to it some or all of it to another individual. This option gives the settlor more control of who benefits from the loan.

A deed of gift will be required. Again, it may be that the loan trust provider offers a draft deed but otherwise a solicitor will need to prepare one.

The gift will be an exempt transfer for IHT if made in favour of a spouse or civil partner, but otherwise it will be a PET.

The new owner of the loan will have the same options as the settlor had. In other words the loan will be repayable on demand in full or in part and any amount outstanding at the date of death will form part of that individual's taxable estate.

Loan options following settlor's death – the importance of updating wills

One of the most important things to consider when establishing a loan trust is to consider what will happen to the outstanding loan and the investment bond following the death of a settlor.

On death, any outstanding loan will be an asset of the settlor's estate and it's likely that it will need to be repaid to the executors/legal personal representatives on death. To repay the loan, some or all of the bond may need to be surrendered and this might create a chargeable event and an income tax liability, assessed on either on the deceased settlor if the event happens in the same tax year as death, or the trustees at 45% if the event happens in a tax year after the settlor's death.

From 6 April 2027 the trustees tax rates on savings income, includin, bond gains will be taxed at 47%. 

To avoid this possibility and the potential for an immediate income tax charge, when the loan trust is set up, the settlors should consider the following options with their legal advisers to ensure that their individual needs are met:

Waiving the loan to the trust

The deceased makes a gift of the loan to the trust in their will. The value of the loan is still included in the deceased's estate for IHT, but the trustees would no longer have to repay the loan to the executors.

The trustees then have full control over the bond and the timing of chargeable events without being encumbered by the loan. For discretionary trusts, when the trustees decide to make a payment to a beneficiary this can often be achieved by assigning the bond, or policy segments.

A chargeable event would then occur when the beneficiary chose to surrender all or part of the bond, and tax assessed on that beneficiary.

If the loan trust is absolute, then any gains would always fall on the beneficiary both before and after the death of the settlor (apart from the situation during the settlor's lifetime where the beneficiary is their minor child). And once 18, a beneficiary can demand that the bond is transferred to themselves.

Note, the executors/LPRs cannot choose to 'waive' the loan to the loan trust themselves. They can only do this if the will instructs them to.

Leaving the loan to spouse/civil partner

This would be an exempt transfer for IHT and this will give the widow(er) the same options for dealing with the loan as the deceased had during their lifetime.

Chargeable events can then be deferred until such time the surviving spouse/civil partner asks for full repayment, or a significant part repayment. When a chargeable event does occur on making a repayment, it will normally be assessed on the trustees at 45%, unless it happens in the same tax year as the settlor's death. However in the case of a joint loan trust, 50% of the gain would be assessed on the surviving settlor. 

The outstanding loan will form part of the surviving spouse's/civil partner's estate for IHT.

Of course with this option, the trustees still have a duty to make sure the loan can be repaid, and this liability means that they are not as free to make payments to the trust beneficiaries.

Leaving the loan to someone else

If the loan is left to another individual who was not the spouse/civil partner then this will be a chargeable transfer for IHT. Again the recipient will have the same options for dealing with the loan as the surviving spouse/civil partner, with the same income tax consequences for the bond when a loan repayment is requested.

Similarly, the trustees must be mindful of the loan before paying any benefits to the trust beneficiaries.

Leaving loan to spouse/civil partner if alive, or otherwise to trust

It is also possible to combine the options above. The loan could be passed to the surviving spouse if they survive the settlor but otherwise waived in favour of the trust. The transfer would be IHT exempt if the spouse survives the settlor but chargeable if it is waived.

By dealing with the outstanding loan in one of these ways it's possible to avoid the full repayment of the loan following the death of the settlor. This should give the trustees greater ability to manage the timing of chargeable events that are assessed on the trust.

Tax considerations when repaying the loan on death

Discretionary/flexible trusts - often the bond is set up with additional lives assured, or on a capital redemption basis, and will continue after the settlor's death. If part of the bond needs to be surrendered by the trustees to repay the loan, the trustee could use any remaining tax deferred allowance to repay the loan.

However, if the amount required is in excess of the 5% tax deferred allowance if might be better to consider repaying the loan by surrendering whole segments. This is because where withdrawals are taken across all segments (i.e. partial withdrawal) any amount in excess of the 5% tax deferred allowance is classed as a chargeable gain, even if there is little or no growth on the bond. Whereas where whole segments are surrendered, the gain will be the actual investment gain, which might be smaller than the gain created by the partial surrender. Comparisons would need to be done to work out the most tax efficient method of surrender.

Where the loan needs to be repaid prompt action might be required to avoid any gain being taxed at the trust rate of 45% (with no top slicing relief). This is because the trust rate applies to any gains occurring in a tax year after the death of the settlor. Whereas any gains occurring in the same tax year as death, are assessed on the deceased settlor (with the benefit of top slicing relief).

Tip: a gain created by partial surrender across all segments occurs on the policy anniversary. Check that the policy anniversary is in the same tax year as death to avoid the gain being assessed on the trust.

Absolute trust - any chargeable gains that arise on or after the settlor's death will always be assessed on the beneficiaries of an absolute trust with the benefit of top slicing relief.