The importance of dealing with any outstanding loan under a loan trust

Reminder of how a loan trust works.

The trust is normally set up with a promise of a cash loan to trustees. The trustees would then commonly invest the amount lent in a single premium investment bond. The trustees can then use the 5% cumulative tax-deferred withdrawal facility under the bond to repay the settlor’s loan during the settlor’s lifetime. On the settlor’s death, it is generally the case that any outstanding loan amount is repayable to the settlor’s estate and would then be distributed in accordance with the terms and provisions in the will/under the law of intestacy.

Of course, if the loan has already been repaid to the settlor during their lifetime, there would then be no outstanding loan to deal with. However, in a number of cases the loan will not have been fully repaid and that outstanding loan would be repayable to the settlor’s estate.

From a practical perspective it is important to note that the personal representatives have a duty to call in all of the deceased’s assets, unless the will specifies otherwise, so this would include the amount of any outstanding loan.

If the bond is written on the sole life of the settlor then, at the time of the settlor’s death, the bond will pay out and any chargeable event gain would be taxable in accordance with the settlor’s rate(s) of income tax in the tax year of their death.

Even if the bond is written on a multiple lives basis, the trustees of the loan trust may have to encash the bond to repay any outstanding loan. This in turn would give rise to a chargeable event for income tax purposes and any gain, under the terms of a discretionary loan trust, would be taxable in accordance with the settlor’s rate(s) of income tax if surrendered in the same tax year as the settlor’s death. If the trustees surrender the bond in a later tax year, any chargeable event gain will be assessable on the trustees at the trust rate of 45% (25% for an onshore bond) to the extent any gain causes the standard rate band, which is usually £1,000, to be exceeded. Those gains falling within the standard rate band will not be taxed if the bond is a UK bond or taxed at 20% if the bond is an offshore bond.

So, what, if anything, can be done to prevent the forced encashment of the bond?

It is possible, and indeed advisable, for the settlor to make specific provision in their will to deal with any outstanding loan. The settlor could, for example, decide that they wish to leave the right to repayment of any loan to, say, a surviving spouse/civil partner. This would mean that provided the beneficiary concerned agreed then, on the settlor’s death, the trustees would not need to surrender the bond and instead could continue to make loan repayments to the surviving spouse/civil partner until any outstanding loan is fully repaid. On the basis that both spouses/civil partners are UK domiciled, this would be an exempt transfer on the settlor’s death and so be free of any inheritance tax.

If the settlor decides to leave any outstanding loan to another specific individual then, from an inheritance tax perspective, this would be treated as a chargeable transfer and thus could then reduce the nil rate band available to the death estate or result in inheritance tax being payable if the nil rate band has already been used elsewhere.

Alternatively, the settlor could decide to leave any outstanding loan to the trustees of the loan trust to hold on the terms of the trust. In this situation the trustees would hold the trust fund – which would include any outstanding loan and any growth - upon the terms of the trust. This means that the trustees would not be required to make any further loan repayments. Instead they can make payments to beneficiaries as and when they deem appropriate under the terms of the trust. The inheritance tax implications of this would be the same as if the outstanding loan had been left to a specific individual other than the settlor’s spouse/civil partner – so, in effect, the gift of the outstanding loan would be treated as a chargeable transfer.

In cases where the settlor already has a will in place, they can simply execute a codicil to deal with the outstanding loan. This will avoid the need to make an entire new will. Of course, in practice it is advisable for the will to be reviewed every five years anyway so they may wish to redraft their will to deal with the outstanding loan on death.

What if no specific provision is made in the will?

As mentioned above, if no specific provision is made in the will any outstanding loan will form part of the settlor’s estate and the personal representatives would usually need to call in the outstanding loan.

Provided the outstanding loan is not required to satisfy legacies, debts, funeral expenses, taxes etc. it will pass to the beneficiaries entitled to the residual estate. This means that it may be possible for the residuary beneficiaries, provided they are absolutely entitled following an assent by the personal representatives and do not need direct access to the outstanding loan, to give up their rights to the loan by deed of waiver. Alternatively, it can be done by deed of variation within two years of the death of the settlor. However, both these options can give rise to unwanted added complexities.

• Deed of waiver

Where the trust in question is a discretionary trust, any amount waived by the residual beneficiary would be a chargeable lifetime transfer and if the residual beneficiary is also a beneficiary of the trust, this would be deemed to be a gift with reservation for inheritance tax purposes. This would mean that in order to overcome the gift with reservation provisions they would need to be removed as a beneficiary under the trust.

Once the loan has been waived, the bond could continue in force for the benefit of the beneficiaries, and, ultimately, a tax charge at the trust rate could be avoided if the trustees assigned the bond to the intended beneficiary prior to encashment. The receiving beneficiary would then be assessable on any chargeable event gain in accordance with their rate(s) of income tax, subject to top-slicing relief if applicable.

• Deed of variation

Provided the variation is executed within two years of the settlor’s death, the deceased would be treated as making the gift for inheritance tax purposes and a gift (and any possibility of a gift with reservation) by the beneficiary would therefore be avoided. It is, however, important to note that the person(s) entering into the variation will be treated as making an additional gift to the loan trust for income tax purposes.

This option can, therefore, cause complications on later encashment by the trustees. This is because on subsequent encashment, part of the chargeable event gain would be taxable on the trustees (assuming the encashment was made in a tax year following the settlor’s death) and part on the varying beneficiary as a second (living) settlor. Again, this could be prevented by assigning the bond/segments out of the trust to a beneficiary who would then be taxable on any chargeable event gain in accordance with their rate(s) of income tax upon encashment.

It should also be remembered that if the residuary beneficiary is the surviving spouse/civil partner the estate (including the outstanding loan) would pass to him/her free of inheritance tax. However, if the surviving spouse/civil partner then chooses to redirect the outstanding loan in favour of the trust, this could result in additional inheritance tax as the spouse/civil partner exemption would no longer apply to the part of the estate represented by the redirected outstanding loan which would then be treated as passing from the deceased settlor’s estate to the loan trust.

It is clear from the above that by leaving planning until the death of the settlor, this can result in unwanted complexities – be it from a tax perspective or in the form of additional legal costs. We therefore strongly advise that clients are encouraged to ensure their will deals with any outstanding loan at the time the planning is implemented.