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Loan Trust

Loan Trust & Inheritance Tax Planning

A Loan Trust suits clients who want to engage in inheritance tax (IHT) planning but still retain access to their original capital. A loan trust involves the settlor lending money to the trust, rather than gifting it outright. It gives flexibility: the settlor can waive portions or all of the loan whenever desired, gradually giving up access if needed. The loan is interest free and repayable on demand. The growth on the trust assets is outside the settlor’s estate for IHT purposes (though the outstanding loan remains part of the estate). Any future growth on the trust assets occurs outside the settlor’s estate.
Loan Trusts offer significant IHT benefits, as they allow the value of the outstanding loan to remain in the estate while ensuring that future growth is outside the estate, helping to reduce the overall IHT liability for the settlor and beneficiaries.

What Is a Loan Trust?

A Loan Trust is designed for an individual establishing a trust for IHT planning but who hesitates to lose access to their money. Under this structure:

  • The client (settlor) makes a settlor’s loan to trustees, who invest via a bond.
  • The growth of that investment is treated as owned by the trust (and not in the settlor’s estate), while the original settlor’s loan remains in the settlor’s estate.
  • The settlor can withdraw or “repay” any part of the loan at any time, up to the original amount, often via 5% tax-deferred withdrawals.

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    • Clients can choose between an absolute loan trust, where beneficiaries and their shares are fixed, or a discretionary loan trust, where trustees have flexibility to decide who benefits, in what shares, and when.
    • A “Deed to Waive a Loan” is often used, allowing the settlor to relinquish certain loan amounts (for example, using annual IHT exemptions — £3,000 individually or £6,000 jointly).

    The trust is established using a trust deed and a formal loan agreement between the settlor and trustees, ensuring the arrangement is legally valid and compliant.

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    Structuring the Trust

    • The trust must be set up before any funds or bond application is made.
    • The settlor then lends monies to the trustees, who invest the loaned amount into an investment bond. The investment bond serves as the underlying investment for the trust, providing the core assets that back the trust’s financial structure. Investment bonds are commonly used in Loan Trust arrangements due to their tax efficiency and flexibility, making them suitable for managing withdrawals for loan repayments and effective inheritance tax planning.
    • You cannot convert an existing bond into a Loan Trust.
    • Once established, the trust can accept top-ups either as new loans or gifts (depending on deed provisions).
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    Interest in Possession Trust

    Who Has Access to the Funds?

    • The settlor may reclaim any part of the interest free loan at any time, as the loan is interest free and repayable on demand. Regular repayments or regular loan repayments can be arranged, and trustees must ensure sufficient funds are available for these payments. During the settlor’s lifetime, the settlor retains access to the loaned funds, and loan repayments reduce the value of the settlor’s estate.
    • The trust fund’s growth and any waived amounts are entirely separated from the settlor — they benefit only the trust beneficiaries, which may include a civil partner or surviving spouse. Once the entire loan has been repaid or the loan has been repaid in full, the trust fund is no longer subject to the loan obligation.
    • Trustees typically include a settlor exclusion clause, preventing the settlor from benefiting from the trust’s capital or income. Reservation provisions are avoided in loan trusts, as the settlor’s right to loan repayment does not constitute a reservation of benefit.
    • For Absolute trusts: beneficiaries (once of age) can demand the trust assets; the assets then fall into their estate for IHT. Trust income, if any, may be subject to income tax, and an income tax liability or income tax charge may arise depending on the type of trust and the nature of the income.
    • For Discretionary trusts: a discretionary beneficiary does not have a fixed right to trust assets, and the trustees decide who benefits and when. Beneficiaries cannot force distributions, and those assets are not part of their estate while held in trust.
    • The trust deed governs the operation of the trust, including the process for loan repayment, lump sum withdrawals, and the management of the original investment. Tax liability, tax credit, and tax paid are important considerations for trustees and beneficiaries, especially if the trustees are UK resident trustees.
    • After the death of the settlor or a deceased settlor, the trust fund may become part of the settlor’s estate or the beneficiary’s estate for inheritance tax purposes, and the obligation to pay inheritance tax or iht liability may arise. Future growth and investment growth within the trust are outside the settlor’s estate, and if the bond falls in value, this may impact the ability to make loan repayments.
    • Chargeable gain, chargeable event, or chargeable event gain may arise on withdrawals or assignments, and the timing of these events within a tax year can affect immediate income tax charge or immediate income tax liability.
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    Offshore Trust

    What If the Investment Falls in Value?

    • If the bond’s value decreases, or if the bond falls significantly, the trustees may be unable to make full loan repayment.
    • Trustees must ensure sufficient funds are available to meet loan repayment obligations, but if the bond falls in value and there are insufficient funds, a shortfall may occur.
    • Whether trustees are liable for a shortfall depends on the trust deed’s terms.
    • Often, a clause limits trustee liability to instances of fraud or negligence, so normal investment losses aren’t their responsibility.

    Inheritance Tax Implications

    • No immediate transfer of value occurs when the Loan Trust is set up (it’s a loan, not a gift). The structure of the Loan Trust is specifically designed for inheritance tax purposes, aiming to keep future growth outside the settlor’s estate for IHT calculations.

    • Amount waived (if not exempt) triggers IHT consequences:

      Trust Type Waiver Treatment Notes
      Absolute trust Potentially Exempt Transfer (PET) If the settlor lives 7 years after the waiver, it becomes exempt. If they die within 7 years, it becomes chargeable.
      Discretionary trust Chargeable Lifetime Transfer (CLT) May incur entry charges if total CLTs exceed nil-rate band.
    • Mixing PETs and CLTs can complicate the IHT timeline (potentially stretching back up to 14 years).
    • Discretionary trusts may also face 10-year periodic charges and exit charges. In a Loan Trust, the taxable amount is bond value less outstanding loan.
    • Even though the assessable value for exit or periodic charges is net of the loan, when reporting, HMRC looks at the full bond value, not net value.
    • Example: if bond value is £261,000 and outstanding loan £200,000 → “value” is £61,000; since the bond value exceeds £260,000, reporting is required.
    • Any outstanding loan is counted as part of the settlor’s estate for IHT.
    • Top-ups by gift are taxed as PETs or CLTs based on the date of the top-up.

    A chargeable gain, chargeable event, or chargeable event gain may arise if bond withdrawals or assignments are made within the trust. These events are reported in the relevant tax year and may result in a tax charge for the settlor, trustees, or beneficiaries. The amount of tax paid on such gains or distributions will affect the calculation of the overall iht liability for inheritance tax purposes.

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