How to minimise your inheritance tax bill, and keep control of the cash in your lifetime   How to minimise your inheritance tax bill

Paul Thompson, tax and estate planning consultant at Canada Life, writes exclusively for What Investment on a method that allows people to minimise their inheritance tax bill, but have access to the cash throughout their lifetime.

 How to minimise your inheritance tax bill

 

Paul Thompson, tax and estate planning consultant at Canada Life, writes exclusively for What Investment on a method that allows people to minimise their inheritance tax bill, but have access to the cash throughout their lifetime.

Paul Thompson, tax and estate planning consultant at Canada Life, writes exclusively for What Investment on a method that allows people to minimise their inheritance tax bill, but have access to the cash throughout their lifetime.

One of the best defences against the potential ravages of inheritance tax (IHT) is an arrangement which, initially at least, has no impact.

In addition, the arrangement allows you to access your capital whenever you want during your lifetime, without generating the potential stumbling blocks that can trip up IHT planning, such as creating a ‘gift with reservation’ or running into problems with the pre-owned assets income tax legislation.

Let’s start with a simple scenario without a trust. Archie decides to lend £1 million to Brenda. He arranges the loan in such a way that it is repayable on demand and, in order to avoid unnecessary complications, he makes it interest-free.

The fact that it is repayable on demand is an important point from an IHT point of view. This is because if it is repayable on demand, the value of the lender’s estate is exactly the same before and after the loan. This prevents the loan being classed by the IHT legislation as a ‘transfer of value’ that may be subject to IHT.

Future growth

So how is that of benefit as far as Archie’s potential IHT liabilities are concerned? If he died the day after the loan was granted to Brenda, there would be no benefit at all; the value of Archie’s estate would be exactly the same as if he had not made the loan. 

However, any future growth on the borrowed money will accrue within Brenda’s estate, not Archie’s, which is the fundamental point here.

By lending the cash interest-free and making the loan repayable on demand, Archie has effectively put a cap on the potential for IHT, since the value of the loan cannot increase. Not only that, but Archie can rest assured that, should he ever need any funds, he can always ask for part or all of the loan to be repaid.

Read more: How can probate trusts help in estate planning

But there’s a potential difficulty. What if Archie is concerned about Brenda’s willingness or ability to pay? Or what if Brenda is under the age of majority so she couldn’t agree to the loan?

Perhaps it would be preferable for Archie to create a trust for Brenda’s benefit so that, having appointed trustees, he could lend the cash to them on exactly the same terms.

In turn, the trustees could invest the borrowed cash so that future growth accrued within the trust. Even better, Archie could create a discretionary trust, allowing for greater flexibility in the event of a future change of circumstances.

Regular partial repayments

A potential problem here is that, if the trustees invest in an income-producing investment, income tax complexities arise in the event of any loan repayment in whole or in part.

Consequently, it is helpful if the trustees take out an investment bond, since it is a non-income producing vehicle. Even better, investment bonds enable up to 5 per cent tax-deferred withdrawals each year for at least 20 years. This means that Archie could have regular partial repayments of capital which he could spend as if they were income.

This is the basis of most loan trust arrangements offered by product providers within the financial services industry.

Read more: How to use a life assurance policy to minimise your inheritance tax bill

Starting these loan trusts is usually straightforward, with no IHT payable at outset. This means that there can be no IHT exit charges on any capital paid out to the beneficiaries within the first ten years of the trust. Nor will there ever be any IHT charges on loan repayments to the person who made the loan.

There will, however, potentially be regular charges at each ten-yearly anniversary but these are based only on the growth on the money borrowed by the trustees, not the underlying loan amount. Indeed, with some careful planning, there should never be a ten-yearly or an exit charge on any discretionary loan trust.

With larger loans to the trust and, indeed, in most situations where such trusts are needed, professional advice on financial planning is a must because multiple trusts may be needed to prevent the growth in the loan trust breaching the IHT threshold of £325,000.

One last aspect of loan trusts must be kept in mind. What happens if the value of the investment bond taken out by the trustees reduces in value to such an extent that the trustees’ liabilities (the outstanding loan) exceed their assets (the investment bond)?

If they receive a demand for repayment of the loan, many loan agreements are worded in such a way as to make the trustees personally responsible for the shortfall arising in these circumstances.

However, some loan agreements provide the trustees with some protection by limiting their liability. These agreements specify that the trustees’ liability is limited to the lower of the outstanding loan and the value of the trust fund.

This is a great comfort to many trustees since they know that, if they act prudently and the value of the trust fund goes down through no fault of their own, they will not be liable to make up any shortfall between the outstanding loan and the value of the trust fund.

 

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