While giving away assets and hoping to live for seven years afterwards can take them out of the taxman’s reach for inheritance tax purposes, the downside is that you lose the right to benefit from those assets. Further, any attempt to give something away but continue to benefit from it is ineffective from a tax planning perspective as it is caught by the gifts with reservation rules.
However, for those who want to engage in a bit of inheritance tax planning but cannot afford to give away their assets, a loan trust offers something of a half-way house.
What is a loan trust?
As the name suggests, a loan trust involves a loan and a trust. A trust is set up, which can be an absolute trust or a discretionary trust, and trustees are appointed. The settlor can also be a trustee.
The settlor makes a loan to the trust. The loan is invested in an investment bond with the potential for growth. The original loan is repayable, usually in regular instalments.
Although the original loan remains part of the settlor’s estate, any growth is outside of the estate.
The settlor retains his original loan, which is repayable on demand. Repayment can be made in regular instalments, as a single sum, or as occasional repayments. Regular repayments can be agreed with the trustees at the time that the loan trust is set up.
The repayments can be made `tax-free’ over 20 years (5% of original amount) by partial surrender of the policy.
Absolute v discretionary trust
Where an absolute trust is used, the beneficiaries and their share of the fund must be specified when the trust is created. A discretionary trust provides the flexibility to change the beneficiaries and their share.
Discretionary trusts are subject to the tax charges, and these should be taken into account.
The trust can include a clause to waive repayment if the loan has not been fully repaid on the death of the settlor, so that the trustees can pay the balance out for the benefit of the beneficiaries.
A loan trust is not for everyone. The settlor loses the right to any growth arising from the investment. Also, investments can go down and financial advice should be sought. If the settlor can afford to make a gift of the capital, this is a better option (from an IHT viewpoint) than using a loan trust. Any loan which has not been repaid at the time of the settlor’s death forms part of his estate.
The benefit to the settlor also runs out once the loan has been fully repaid and his income source ceases.
Should you need further advice on inheritance tax planning and setting up a loan trust or for any other tax related matters get in touch with Inform.
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