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Loan plans on death

Loan plans are regularly used in inheritance tax (IHT) planning, particularly if an individual wishes to reduce the IHT liability on their estate but also retain the ability to receive an “income” from the amount gifted through repayments of the loan. The options available on the death of the person who has set up the gift and loan plan (the “Settlor”) are outlined below.

Loan plans: what are they?

In summary, in a loan plan:

  • The individual wishing to save IHT lends funds to a discretionary trust (“DT”), repayable on demand.
  • The trustees invest the loan funds in an investment bond, sometimes held offshore.
  • Repayments of the loan are subsequently made to the Settlor utilising the 5% tax free withdrawal facility, reducing the amount of the loan included in the Settlor’s estate.
  • The expected capital growth on the amount invested takes place outside of the Settlor’s estate. The Settlor is excluded from benefiting from the trust fund (or the growth) but is free to spend (or gift) the loan repayments as they wish.

The IHT position on the Settlor’s death

On the Settlor’s death, the value of the investment bond held within the DT is outside of their estate.  However, the balance of the loan owed to the Settlor, will be an asset of their estate and potentially subject to IHT.  It is advisable for Settlors to include provisions in their Will to determine what will happen to the outstanding loan.

If no specific provision is included in the Settlor’s Will (or the Settlor does not have a valid Will), the benefit of the loan will fall into the residue of the Settlor’s estate. The loan is owed by the DT to the estate, but any value in excess of the loan continues to be held on trust for the DT beneficiaries. The executors have a duty to collect in the estate which (in the absence of other provisions, or agreement with the beneficiaries) would include the outstanding balance of the loan. Therefore, the DT trustees will have to surrender part of the investment bond to release funds.  This is likely to result in a charge to income tax under the ‘chargeable events’ legislation of up to 45%.

What other options exist on death?

In the absence of any specific provision in the Will, it may be advantageous to avoid a forced surrender of part of the investment bond (and the consequent chargeable event income tax charge). The best course of action will depend on the individual circumstances of the particular estate and trust, but broadly there are three potential courses of action:

1. Leave the loan in place

If the residuary beneficiaries agreed, the loan could remain in place with the trustees making repayments to the beneficiaries in the same way as before the Settlor’s death. The loan would be appropriated to the residuary beneficiaries of the estate. The existence of the loan would continue to be a liability of the trust which could reduce any potential IHT periodic charges on the trust (see below). The loan would be an asset of the residuary beneficiary’s estate, depreciating as repayments are made.

2. Waive the loan

The residuary estate beneficiaries could waive the benefit of the loan in favour of the DT. This would mean that the value of the loan is now held for the benefit of the DT beneficiaries, who may be the same or different to the estate beneficiaries.  This may avoid encashing part of the bond and triggering the chargeable event gain.

If not covered by an exemption, this would be a lifetime chargeable transfer by the estate beneficiary for IHT purposes.  Depending on the value and the beneficiary’s available IHT nil-rate band, this could mean up to a 20% tax charge and may also lead to the trust being settlor interested and so would need careful consideration. In practice this option will only be used where the DT is to be brought to an end so that the beneficiaries own the DT assets.

In order to waive the loan, it is necessary to take the following steps:

  • The DT trustees appoint the benefit of the DT trust fund to the DT beneficiaries.
  • The executors appropriate the loan balance to the estate beneficiaries.
  • Assuming the DT and the estate have the same beneficiaries, at that point they owe themselves the debt. They must then enter into a deed of waiver to cancel the debt.
  • The segments in the bond are then assigned to the DT beneficiary and they encash them. The tax position is different for the beneficiary. The tax charged will benefit from ‘Top Slicing Relief’ and will be at their marginal income tax rate.

If the Settlor had made adequate provision in his Will, many of these steps would have been avoided.

3. Deed of variation

A deed of variation could be signed within two years of the deceased’s death to incorporate a gift into the Settlor’s Will (so it is as if the gift occurred on the Settlor’s death).  This would leave the benefit of the loan to the DT trustees for the benefit of the trust beneficiaries. The gift would use some of the deceased’s IHT nil rate band, but would mean that the loan would remain outside of the residuary beneficiaries’ estates and they would not be making a chargeable event for IHT purposes.

If the deceased had made substantial gifts in the seven years before their death, then there may be insufficient of their nil rate band to use against the gift. As this would potentially give rise to an IHT charge on an estate (which might otherwise be free from IHT because of the spouse exemption), care would need to be taken in these circumstances.

Further, if there is more than one DT and the loan is treated as waived on death due to the deed of variation, then the ‘same day addition’ rules would apply meaning that the DTs would effectively share a nil rate band for the purposes of the ongoing anniversary and exit charges.  Depending on the value, this could result in higher ongoing IHT periodic and exit charges.

Deciding how to proceed

The trustees and the beneficiaries will need to consider the comparative tax positions of the above options and of all the beneficiaries involved in order to make the best decision. It should also be noted that the DT will need to be registered with the trust registration service (it should have been registered in any event by 2021) and if the assets in the trust exceed 80% of the IHT nil rate band, then an IHT return will be required every ten years on the anniversary of the trust’s creation. If the value of the trust assets at that point exceeds the IHT nil rate band there will be a periodic IHT charge at a maximum rate of 6%.

Planning opportunities

We are increasingly seeing cases where loan plans have not been considered during deceased client’s Will planning or during the administration of their estate. This is generally where the solicitors or Will writers dealing with the Wills or estates are unfamiliar with loan plans and the consequences of them and have simply ignored them with costly consequences.

The preferred course is for the Wills to make provision for the loan plans. This simplifies the administration of the estate and the taxation consequences for the loan plan and means that there is no need to disturb the underlying loan plan investments. The asset protection and tax efficiency of the trust arrangement can be cascaded down the generations.

We recommend that the Wills of clients with loan plans are reviewed to ensure that there is adequate provision. If there is insufficient provision, a codicil is a cost effective remedy if a full will review is not otherwise appropriate.