A loan trust helps you pay less inheritance tax and keep access to your money. Read on to find out what a loan trust is, how it works and the benefits.
Key Points
- A loan trust allows you to invest your assets while keeping growth out of inheritance tax, so it’s a great estate planning tool if you have a lot of assets.
- There are two types of loan trusts: Absolute Loan Trusts which have pre-determined beneficiaries and shares and Discretionary Loan Trusts which give the trustees flexibility in asset distribution.
- Managing a loan trust requires careful planning, including regular communication between the trustees and the settlor and adherence to legal and regulatory requirements to avoid complications.
What is a Loan Trust?
A loan trust is a special arrangement that allows trustees to invest assets while keeping any growth out of inheritance tax. This is especially useful for people with estates over the inheritance tax threshold who want to keep access to their assets. Essentially it’s a way to invest your money without increasing the value of your taxable estate so you can save inheritance tax (IHT).
One of the key features of a loan trust is the loan to the trust is interest free and repayable on demand. This means the settlor can withdraw the original loan amount at any time and the investment growth is protected from inheritance tax. This double benefit makes loan trusts a great option for inheritance tax planning and asset management. Loan trusts for inheritance tax planning are particularly beneficial for those new to inheritance tax planning who may be hesitant to relinquish their savings, as they allow clients to maintain access to their capital while protecting the growth of the trust from inheritance tax.
How to Set up a Loan Trust
Setting up a loan trust involves several key steps. It starts with the creation of the trust then the loan agreement. It’s simple but requires attention to detail. First the trust is created, then the loan is made and finally the trustees invest the funds, often into an investment bond. This structured approach ensures the trust runs smoothly and in line with the legal requirements.
Appointing trustees is a critical part of setting up a loan trust. Trustees must be appointed alongside the settlor to validate the loan. The loan to the trustees must be in cash and the agreement must state no interest is charged.
Key is that the settlor is lending not gifting the funds so no inheritance tax applies when the loan trust is created. This allows you to manage and grow your assets while keeping control of the original loan amount.
Types of Loan Trusts
Loan trusts come in two main forms: Absolute Loan Trusts and Discretionary Loan Trusts. Knowing the difference is crucial for effective management and inheritance planning. An absolute loan trust has pre-determined beneficiaries and shares which cannot be changed by the trustees.
A discretionary loan trust gives the trustees the flexibility to decide how and when to distribute the trust assets to the beneficiaries. These differences affect how each type of trust works and serves the settlor and beneficiaries.
Absolute Loan Trust
An absolute loan trust requires beneficiaries to be named and their shares to be specified when the trust is created. Once the beneficiaries are set the shares cannot be changed so there is certainty and clarity to the trust structure. This rigidity can be useful for settlors who want to ensure specific individuals get specific parts of the trust fund.
However you can turn an absolute loan trust into a gift trust by waiving the loan. This involves creating a deed of waiver, formally giving up the settlor’s right to the loan. This releases the trustees from the loan and can have tax implications and change the nature of the trust and potentially more tax benefits.
Discretionary Loan Trust
Discretionary loan trusts are more flexible than absolute trusts. In a discretionary loan trust the trustees have the power to decide how and when to distribute the trust assets to the beneficiaries. This means the beneficiaries do not have fixed rights to the income or capital of the trust so the trustees can adapt the distribution to the beneficiaries changing circumstances.
The flexibility of discretionary loan trusts is a big plus. It allows the trust to respond to the changing financial needs of the beneficiaries over time. This can be especially useful in managing the trust assets and making sure the beneficiaries get support in line with their current circumstances.
How Loan Trusts Work
A loan trust works when the settlor lends money to the trust which is then invested by the trustees into various assets, often an investment bond. This investment strategy grows the trust fund with the growth belonging to the trust beneficiaries and outside the settlor’s estate for inheritance tax purposes. This ensures the growth is not added to the settlor’s estate.
Another benefit of a loan trust is it’s interest free. The loan from the settlor is interest free and can be repaid at any time. The trustees can use the 5% tax deferred allowance from the bond for loan repayments without incurring immediate tax. This is a tax efficient way to manage loan repayments and keep the trust healthy.
Also if the settlor no longer needs the loan they can choose to waive or gift it. This can further enhance the tax efficiency of the trust by reducing the settlor’s taxable estate and more benefits to the beneficiaries. Knowing these mechanics is key to getting the most out of a loan trust.
Tax Benefits of Loan Trusts
Loan trusts have several tax benefits especially for inheritance tax. By not adding the growth of the loan to the estate the loan trust can reduce potential inheritance tax liabilities. The growth within a loan trust is outside the settlor’s estate for inheritance tax purposes so it’s a tax planning opportunity for inheritance tax. However, any outstanding loan remains part of the settlor’s estate and must be considered in overall estate planning.
Also individuals can withdraw up to 5% of their original investment from a loan trust each year without incurring an immediate income tax charge. This is a tax efficient way to access funds and defer income tax. Each waiver of the loan can use the IHT annual gift allowance so there’s tax efficient reduction of the outstanding amount. These tax benefits make loan trusts a powerful tool for managing wealth and reducing tax, especially when considering the estate for IHT purposes.
Beneficiaries may however have inheritance tax implications on the value of the trust assets and any outstanding loans when the settlor dies. So careful planning and strategic use of loan waivers is key to get the most tax benefits and keep the trust healthy especially when they may have to pay IHT.
Access to Funds
One of the big plus of a loan trust is the settlor can access the interest free loan amount at any time. This flexibility allows the settlor to call back the loan in whole or in part and have a practical way to manage their financial needs without compromising the trust structure. Beneficiaries have no entitlement to the outstanding loan. This is stated in the trust.
The distribution of trust assets to beneficiaries can be affected by whether the settlor’s outstanding loans are forgiven or not. If the loan is not forgiven beneficiaries will have to repay it which can affect their inheritance. This is why strategic planning is key in managing loan trusts to balance the settlor’s needs and the beneficiaries’ interests.
Loan Repayment Options
When it comes to repaying loans within a trust the trustees have several options. They can use the 5% tax deferred withdrawal from bonds for loan repayments without incurring tax. If the settlor no longer needs the loan they can choose to waive or gift the loan. This should be done through a formal deed to ensure legal compliance.
Trustees’ flexibility in loan repayments can make a big difference to the trust’s financial strategy and tax efficiency.
Regular Repayments
Regular repayments of the loan is a common way to manage the outstanding loan within the trust. Trustees should keep track of these repayments to prevent the settlor from getting more than the original loan amount and keep the trust healthy. This tracking is important to avoid complications with excess repayments and trust management especially when thinking about how to repay the loan.
The settlor may also choose to take ad hoc repayments instead of regular ones and have flexibility based on their income needs. Having a structured repayment schedule however can help avoid complications and keep the trust running smoothly.
Waiving the Loan
Waiving the loan is another repayment option that has tax implications. For an absolute trust waiving the loan is a potentially exempt transfer (PET) with no immediate IHT charge. This requires a waiver document to be created, formally giving up the settlor’s right to the loan. If the settlor waives their right to the whole loan it converts the trust into a gift trust.
Trustees must consider the outstanding loan when paying benefits to beneficiaries. Leaving the loan to someone other than a spouse or civil partner will incur a chargeable transfer for IHT. So strategic planning and tax implications must be considered when waiving the loan.
Loan Trusts on Death
Managing loan trusts on death is complex. The outstanding loan is part of the settlor’s estate for IHT purposes. Regular tracking and documentation of loan repayments is important for trustees to avoid trust breaches.
Settlors should update their wills to state how the outstanding loans are to be dealt with on death. This will ensure the distribution of trust assets is managed properly and in accordance with the settlor’s wishes.
What Trustees Do When Settlor Dies
On the settlor’s death the outstanding loan will be part of their estate and subject to IHT. Trustees must consider what to do with the outstanding loans at this time, repayment or retention. This means deciding whether the outstanding loan should be repaid to the estate or managed within the trust. The outstanding loan becomes an asset of the settlor’s estate and will need to be repaid.
Trustees also need to notify beneficiaries and manage the distribution of trust assets on the settlor’s death. This includes making sure any instructions in the will regarding the loan and trust are followed. Proper management and clear communication during this period is key to keeping the trust healthy and fulfilling the settlor’s wishes.
Beneficiaries
The death of the settlor has big implications for the beneficiaries of a loan trust. The outstanding loan is part of the settlor’s estate for IHT purposes. Beneficiaries will have different outcomes for the distribution of trust funds based on the settlor’s debts and tax obligations. If the outstanding loan is not forgiven beneficiaries may have to repay it which will affect their inheritance and the net value of the assets they get.
Trustees may have an obligation to pay inheritance tax resulting from the beneficiary’s passing.
Also the loan and tax liabilities will affect how the trust assets are distributed. Beneficiaries need to be aware of these obligations and plan accordingly.
Trustees have a key role in managing these transitions smoothly and making sure beneficiaries know their responsibilities and the impact on their inheritance.
Updating Your Will
When establishing a Loan Trust, it is essential to consider the implications of the outstanding loan on your estate for Inheritance Tax (IHT) purposes. To ensure that your wishes are carried out and to minimize potential IHT liabilities, it is crucial to update your will.
Updating your will to reflect the existence of the loan trust and the outstanding loan amount is a vital step in inheritance tax planning. This ensures that your executors are aware of the loan trust and can manage the outstanding loan appropriately. By clearly stating how the outstanding loan should be handled upon your death, you can help prevent any confusion or disputes among your beneficiaries.
Moreover, specifying the repayment terms of the outstanding loan in your will can provide clarity and direction for your trustees. This can include instructions on whether the loan should be repaid to your estate or forgiven, which can significantly impact the inheritance tax calculations. Properly documenting these details can help reduce the IHT burden on your estate and ensure a smoother transition of assets to your beneficiaries.
In summary, updating your will to include details about your loan trust and outstanding loan is a crucial aspect of effective inheritance tax planning. It helps ensure that your financial affairs are managed according to your wishes and can provide significant tax benefits for your estate and beneficiaries.
Loan Trust Drawbacks
While loan trusts have many benefits they are not without drawbacks. Legal complexities can arise and need to be carefully managed to avoid issues. For example waiving amounts from a discretionary trust can create a chargeable lifetime transfer (CLT) and an entry charge. Receiving more than the loan amount can trigger IHT on growth and a trust breach.
Also loan trusts can have many disadvantages such as no guaranteed rights for beneficiaries and complexity in management. Trustees need to manage these risks while complying with legal and tax rules. Understanding these pitfalls is key for anyone considering a loan trust to make informed decisions and avoid unintended consequences.
Loan Trust Best Practice
Managing a loan trust properly requires best practice. Here are some key points to consider:
- You must consult a financial advisor to navigate the loan trust complexities and tax implications.
- Trustees have the power to make decisions that may not always be in line with the settlor’s wishes which can create conflict.
- So clear communication and documented agreements are essential to keep things harmonious and transparent.
Running a loan trust also requires compliance with regulatory requirements such as registration and annual tax filings to avoid penalties. Setting up and managing a loan trust can be costly and needs to be managed carefully to be long term sustainable. By following these best practice trustees and settlors can get the most out of loan trusts and make them work.
Conclusion
In summary loan trusts are a powerful way to manage assets and reduce IHT liabilities. By understanding the different types of loan trusts, the process of setting them up and the different repayment options settlors and trustees can make informed decisions that benefit the settlor and the beneficiaries. The tax benefits especially IHT and income tax make loan trusts a great option for strategic planning.
But running a loan trust requires attention to legal and regulatory rules and clear communication between all parties. By following best practice and seeking professional advice trustees can manage loan trusts successfully. With the right approach loan trusts can be very financially and tax efficient and secure the financial future for the settlor and their beneficiaries.
FAQs
What is a loan trust?
A loan trust is an arrangement where trustees invest assets and the growth is outside the estate for IHT purposes. This can be an estate planning solution.
How do I set up a loan trust?
To set up a loan trust you establish a trust, lend money to the trustees and clearly state that the loan is interest free and repayable on demand. This will keep things clear and simple for the trust’s financial arrangements.
What are the types of loan trusts?
There are two main types of loan trusts Absolute Loan Trusts and Discretionary Loan Trusts. Each type has different purposes for asset management and distribution.
What are the tax benefits?
Loan trusts can reduce IHT by keeping the growth outside the settlor’s estate and defer income tax on withdrawals. This is a great planning opportunity.
What happens to a loan trust when the settlor dies?
When the settlor dies the outstanding loan is part of their estate for IHT purposes and the trustees will manage the distribution of the trust assets.
