I have recently been advised on Estate Planning Inheritance and have been told that I should set up a loan trust arrangement, is this my best option?

That’s a difficult question to answer without knowing your full circumstances, however I understand this is primarily promoted by life insurance companies who would like you to invest your cash into their own investment funds.

Let’s look at an example of a client who had been advised to do this by a life company, and later advised that he could reduce IHT and income tax charges by waiving the right to some, or all, of the outstanding loan repayment…..

When Dennis Barnes was aged 56, he was a 40% taxpayer, and understood that in the event of his death, the size of his estate would mean that a substantial amount of inheritance tax (IHT) would be payable, which would reduce the amount his children could inherit.

Although he could afford to gift some capital to his children, this caused him some concern:-

  1. If his children got divorced their partners might make a claim against their assets (so effectively he could be gifting up to 50% of his money to a stranger).
  2. What if his circumstances changed at a later date?

He was advised to settle £100,000 into a loan trust arrangement using a discretionary trust, so he would have access to the original capital via loan repayments, also any increase in value would fall out of the estate and into the trust arrangement.

The trustees then invested these monies into an investment bond written in 100 identical segments, and Dennis’s two children were named as additional lives assured to allow for greater flexibility.

Five years later, Dennis has taken no loan repayments and is still a a high rate taxpayer. At the start of year six the investment bond is worth £130,696, having grown by 5.5% each year net of charges. Each segment is therefore worth £1,306.96.

Therefore £30,696 is outside of Dennis’s estate for IHT purposes, saving a potential £12,278 in IHT.

However, the outstanding loan of £100,000 still forms part of Dennis’s taxable estate on death. He has now decided he will give up his rights to around half the loan (£50,000).

What options are available for him to give up the rights to the loan?

The life company advised

The two possibilities open to Dennis: are that he could demand part repayment of the loan and gift the cash generated; or he could waive her rights to some or all of the outstanding loan in favour of the discretionary trust.

Loan repayment option

If Dennis took this option, it would be up to the trustees to extract funds from the bond to repay him. There are two ways they could go about this. They could either surrender some segments or take a partial withdrawal from every segment. Surrendering 39 segments, roughly equivalent in value to half of the loan, would result in a lower chargeable gain.

  • Segment surrender:
    39 segments x £1,306.96 = £50,971.44, minus the original value of 39 segments, £39,000, (39 x £1,000) leaves a chargeable gain of £11,971.44
  • Partial withdrawal:
    £50,971.44 is surrendered, minus £30,000 (5% per annum of tax on the £100,000 investment deferred over six years) leaves a chargeable gain of £20,971.44.

The chargeable gain would be taxed on Dennis as he is the settlor. As a higher rate taxpayer, he would have to pay, on segment surrender, tax of £2,394.28 (20%) for an onshore bond and £4,788.56 (40%) for an offshore bond.

The proceeds, net of the income tax liability, could be gifted to the two children as a potentially exempt transfer.

However, this is clearly not a sensible approach as there the disadvantages of incurring an income tax liability and a loss of control if an outright gift is made to the children.

Waiving rights to the loan

If Dennis instead waived his rights to some or the entire outstanding loan in favour of the discretionary trust, this would be a ‘transfer of value’ for IHT purposes. Where this waiver exceeds any available annual exemptions for IHT purposes, the excess will be a chargeable lifetime transfer.

Where the settlor was excluded from benefiting under the trust, this would not give rise to a gift with reservation. To be effective, any waiver must be made by deed, otherwise HM Revenue & Customs will not accept it as being valid.

Each year, Dennis could use his annual IHT gifting exemption by waiving a further £3,000 in favour of the trust.

The waiver option avoids the encashment of the bond and therefore a potential chargeable event arising. Also the beneficiaries under the trust benefit from the loan waiver.

Funds can also remain invested and the trustees have control over the monies and when the trust fund is distributed to the beneficiaries.

This complex proposal is designed to put a client in “control of his assets” but also save inheritance tax. However what you are really doing is passing control of the future value of your investments to a life insurance company internal fund!

Inheritance Tax Planning or Estate Planning should be considered using trusts that are independent of the life insurance companies, that way you can be sure you are really in control of your financial affairs.

Ray Best can help you protect your financial future. To find out more, simply click here!

About Ray L Best

Ray Best has had over 30 years experience of advising on complex financial matters. A published author of a number of books including “Partnership and Shareholder Protection”, Inheritance Tax Simplified”. We provide an initial meeting at no cost and only engage with clients when we can add significant value.

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