Barrie Dawson, Senior Technical Manager, M&G, looks at the use of loan trusts in IHT planning and tackles two common questions asked, with an example.
Loan Trusts allow clients to keep access to their original capital and ensure any growth on their capital will be outside their estate for IHT purposes. For the avoidance of doubt, the outstanding loan remains in the settlor’s estate for IHT purposes.
A typical loan trust scenario is where it is the client’s first introduction to IHT planning. They may not like the idea of giving away a large sum of capital outright, so using a Loan Trust allows them to retain control and gives them access to their original capital. Another scenario is when the client has exhausted outright gifts into discretionary trust and further chargeable lifetime transfers would give rise to an entry charge. However, they want to do some planning now to avoid future growth on the remaining capital held from being included in their estate for IHT purposes.
A Loan Trust is normally set up first. The trustees will then invest the loan amount and the investment is typically an investment bond. When it comes to managing loan repayments to the settlor(s), or distributing trust capital to beneficiaries, the trustees will need to take a withdrawal from the bond to meet the payment.
Bonds (onshore & offshore) provide two withdrawal methods:
- Full surrender (includes surrender of individual segments).
- Partial withdrawal (specified amount taken across all segments equally).
Normal chargeable event rules apply when the trustees take a withdrawal from the bond which often causes confusion in relation to Loan Trusts. Two common question are:
- A loan repayment to the settlor is just a return of capital so does that not mean any withdrawals are simply a return of capital and shouldn’t trigger a chargeable event?
- If the growth on the outstanding loan is held in trust for the beneficiaries then surely crystallising investment growth to meet a loan repayment would mean paying trust funds to the settlor and create a breach of trust?
It’s key to understand that there’s no special structure to a bond held by trustees of a loan trust. There isn’t a separate loan and growth element to the bond representing the interests of the settlor and beneficiaries respectively. It’s just a normal bond.
It is the trustees responsibility to keep a record of the loan agreement and how this changes over time (e.g. loan repayments or instances where the settlor(s) have waived part of the loan to the trust fund). The trustees also need to keep a record of distributions made to trust beneficiaries.
If the trustees want to make a payment to the settlor(s) or beneficiaries, they need to consider the tax implications of the different bond withdrawal methods first.
Case study example
Sue sets up a Discretionary Loan trust in December 2020. The initial loan was £100,000 and the full amount was invested in an onshore bond with 20 segments. In January 2025 the bond is valued at £130,000. There has been no bond withdrawals. The trustees can easily identify the current trust fund value (£30,000) by deducting the outstanding loan amount from the surrender value.
Sue decides she needs a loan repayment of £20,000. As the bond is in policy year five there’s unused tax deferred allowance (TDA) of £25,000 available which the trustees could use to meet the loan repayment request without triggering a chargeable event for income tax purposes.
Alternatively, as each segment is worth £6,500 the trustees could surrender three segments, plus take a withdrawal of £500 from the unused TDA available across the remaining 17 segments. This exercise would realise a £4,500 gain on the three segments surrendered.
Sue is UK resident and would be liable for any gain triggered by the trustees. Her only sources of taxable income is her private and state pensions of £30,000 gross (2024/25 tax year). After seeking advice, they decide to crystallise some of the gains built up, rather than opting to kick the tax can down the road with a £20,000 tax deferred withdrawal. A £4,500 gain will not trigger a tax liability for Sue as she would remain a basic rate taxpayer and the 20% tax credit will satisfy the liability.
After making the loan repayment, the trustees need to amend their records to show that the outstanding loan is now £80,000. As the bond is now worth £110,000, they can identify that the trust fund is still £30,000. So while the trustees have realised growth on the bond to repay the outstanding loan, they haven’t paid any of the trust fund to the settlor.
The same principles would apply if the objective was to make a £20,000 distribution to a beneficiary. The trustees would consider the withdrawal methods and tax implications, then adjust their records accordingly. The only difference is they could consider assigning segments to the trust beneficiary as part of the distribution exercise. For example, if Sue was a higher rate taxpayer but the beneficiary had total income of £30,000, the assignment route would be more tax efficient than having the gain assessed against Sue.
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