Family Loans for Inheritance tax planning – cunning plan or can of worms?

In a world where Inheritance Tax (IHT) can be chargeable at 40% on relatively modest estates – perhaps as little as the family home, taxpayers are often keen to devise a cunning plan which will enable assets to be passed tax free to the next generation whilst remaining at least partially within the control of the donor. In general terms this isn’t going to work. Where assets are transferred but the donor retains an interest it is known as a “gift with reservation of benefit (GROB) and will only be effective for IHT purposes when the reservation is lifted.

The high cost of housing and the difficulties experienced by first time buyers can often lead to parents wishing to help children buy their first house – but because they do not wish to completely lose control of the money (or are not completely happy with their potential son/daughter in law) there is a temptation to create some sort of “loan” arrangement in the hope that they can call in the loan if anything goes wrong in future, but if not, it will simply be forgotten and treated as a gift.

This type of arrangement can turn into the proverbial can of worms in a number of different ways. On a practical level, there will always be a fear either that a relationship will turn sour, or the parents will unexpectedly find that they want the money back. If there is no evidence that the transaction was a loan rather than a gift, the parents and the (by now) estranged in-law may have different recollections of the original arrangement (particularly if there is a divorce involved), so it is highly likely that there will be some sort of paper trail.

Further complications can emerge if one sibling has been treated or is THOUGHT to have been treated more favourably than others, who might also have differing recollections of what the original transaction meant, and whether the loan should be brought back into the estate for the purposes of computing the residue. There might even be a possibility that at some stage the parents told the donee that they were waiving the loan and now considered it to be a gift. Again, if that information is not shared with the siblings there may be friction, but there is also an issue here from a tax perspective. A loan waiver is only effective if it is done by a formal deed. From the date of the deed, it will be a potentially exempt transfer and remain on the IHT record for seven years, but more to the point, it will not be effective at all unless it is made under a formal deed of gift.

Finally, there can also be an issue where the loan is waived, and the donee is subsequently assessed by a local authority for care home purposes. Notwithstanding that the loan may have been made many years previously the waiver might be considered a voluntary deprivation of resources in a care cost assessment.

In addition to the practical difficulties during lifetime, the real “can of worms” will explode on death. At that point the executors will discover the paper trail (and the possible absence of a formal deed or waiver) and will then have to decide whether or not to recover the “debt” if it has not properly been released. They will also be obliged to include the loan within the estate for probate. This may mean:

1. An asset which everyone thought would be outside IHT will now be chargeable
2. The siblings who didn’t get the gift will potentially have a larger share of IHT on the remaining estate
3. The previous donee may not be able to repay the loan
4. It is entirely possible that the previous gift may upset careful Will planning, and/or lift the estate over the £2m level at which the additional main residence allowance is lost
5. Where a charitable legacy is intended to bring the reduced 36% IHT rate, the newly discovered asset may reduce the charitable element below 10%, leaving the whole estate within the 40% charge

There can be ways of using family loans, but it is important that the consequences are considered, and the waiver rules fully understood by both parties. As ever, professional advice is essential if unexpected consequences are to be avoided

If you would like to discuss this matter further, please contact Nicola Tarry FCA at Mapus-Smith & Lemmon LLP, Hunstanton office on 01485 534800 or ntarry@mapus.co.uk

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