Avoiding the tax mousetrap

Jeremy Pearson highlights the important role gift and loan trusts can play in an inheritance tax strategy

The gift & loan trust – sometimes simply a loan trust – is a very popular weapon in the financial planner’s armoury. It is one that, if used correctly, can save clients from the ravages of inheritance tax (IHT). The best way to illustrate what can happen is by way of a case study. So let me introduce to you Mr & Mrs King, otherwise known as Charles and Anne. As with many people, Charles doesn’t like paying tax and is determined that HMRC will not get more than their fair share, even after he has gone.

After discussions with his professional adviser, Charles and Anne like the idea of not ­giving money away to their children, but lending it to a trust for them instead.
Trust arrangement

To begin, they make a ­discretionary settlement and set up a trust of which they are the trustees. The ­adviser points out that if they do not want the children to get the trust fund until after their death, then they must appoint ­someone to be trustee after their deaths.

Charles and Anne chose a ­discretionary trust, as opposed to a bare trust, in case the trustees ­decide at a later date to pass ­money on to grandchildren or ­others. Initially, they would expect ­William and Elizabeth to get the trust fund after they both die.

As neither will be around at that time, on the adviser’s suggestion they draw up a short letter of wishes ‘to whom it may concern’, which says the main beneficiaries are to be their children, but consideration should be given to retaining some of the trust fund for any grandchildren and great-grandchildren. Anne’s younger brother Edward agrees to become a co-trustee.

Making a loan

Charles and Anne now each make a loan of £50,000 to the ­trustees (themselves and Edward). The loans are made independently from each of their sole bank ­accounts. There is a loan agreement ­completed by each of them, ­between the lender and the trustees. The intention is that the trustees will then invest the loan.
But Edward raises a concern: the agreement says the trustees have to repay the loan on demand. What if the value of the investment fell and they don’t have all the money? Will he have to cough up himself?

The adviser is able to placate Edward, drawing his attention to a clause in the agreement that says ‘the liability of the trustees to the lender for repayment... shall be ­limited to the assets of the ­settlement from time to time’.

The adviser then raises the ­question of what happens to their outstanding loans if something ­happens to one of them. If no action is taken, it would have to be repaid to the executors on death.

Alternatively, they could change their wills or add a codicil, to leave the loan to the survivor. Or they could just ask their executors to forego the loan and leave the ­balance in the trust as a gift.

Charles and Anne agree that ­repaying the loan on death is ­pointless and say if this happened, they would want the executors to forego the outstanding loan and leave it in the trust for the children. As they are each others’ executor with Edward, and failing that it is the children, that is no problem.

The adviser asks if they need any income at present because if they do so, the trustees can make a ­regular withdrawal from the bond and pass it over as a partial loan ­repayment. Of course, the ­repayments can be made only to the extent of the loan, so they could receive 5% each year for 20 years or 4% each year for 25 years, and so on.

Charles and Anne have no need for income at present, so it is agreed  they will just take loan repayments if they need any money.

The trustees now invest the loans that they have received by buying an investment bond with multiple lives assured. Any growth this bond accrues will be held for the ­beneficiaries and is free from IHT.

First death

After five years, Charles dies. No loan repayments have been made and the investment bond is ­currently worth £125,000. In order to fully administer Charles’s estate, his executors should demand ­repayment of the loan from the surviving trustees (Anne and her brother Edward).

But as he left all his estate to Anne, and she does not require the loan to be repaid, the exactors forego the loan repayment and confirm this in writing to the trustees.
The outstanding loan of £50,000 was still an asset of Charles’s estate for inheritance tax purposes, but as the spouse exemption applied, this is of no consequence.