This issue’s Technical Refresher looks at what to do when a client makes a cash loan to trustees
Adiscretionary loan trust is where the client (referred to as the settlor) makes a cash loan to trustees, who then invest the funds in an investment – commonly an investment bond.
The main benefit of the loan trust is that it enables the settlor/client to have access to the amount lent, with any future investment growth falling outside of their estate for inheritance tax (IHT) purposes. Further, as the settlor has made a cash loan, there is no transfer of value (i.e. gift) for IHT purposes.
Given that the settlor is entitled to the amount loaned, there is no set amount that must be taken under the terms of the trust. Instead, the settlor can decide as and when they would like loan repayments to be made back to them.
In cases where the trustees have chosen to invest the cash in an investment bond, this provides them with flexibility when making loan repayments back to the settlor. This is because the trustees can use the cumulative annual 5% allowance to make loan repayments whenever funds are required. It is, of course, vital that the trustees keep a record of any repayments and ensure that no investment growth is paid to the settlor.
A discretionary loan trust also provides flexibility should the settlor decide that they no longer require loan repayments and wish to make a gift. They can ‘waive’ their right to any outstanding loan. This will, however, give rise to a chargeable lifetime transfer for IHT, so it is important to take account of any chargeable lifetime transfers the settlor may have made in the seven years prior to them deciding to ‘waive’ the loan, as lifetime IHT may be due.
Further, on the settlor’s death, any outstanding loan would be included as an asset of their estate, like any other loan. It is therefore advisable to consider what the settlor would like to happen to any outstanding loan. For example, do they wish for the trust beneficiaries to benefit, or someone else? The IHT implications will vary depending on what the settlor wishes to happen and they ought to make provision for this in their will. If, for example, the settlor decides that the trust beneficiaries should benefit, this will be treated as a chargeable transfer and therefore would use part/all of the settlor’s available nil rate band on their death.
However, if the settlor has not made any provision in their will, the position is more complicated as, ordinarily, any outstanding loan will form part of the settlor’s residual estate and should be repaid and distributed in accordance with the terms of their will. So, if the trustees are required to surrender bond segments/the bond to repay any outstanding loan, this would usually give rise to income tax on any chargeable event gain. If the surrender takes place in the same tax year as the settlor’s death, the chargeable event gain will be assessable on the settlor in that tax year, but if the encashment is in a later tax year, any income tax liability would usually fall on the trustees at the trust rate of 45% (25% for an onshore bond) subject to the standard rate band, which is usually £1,000, provided this is the only trust established by the settlor.