Cross-border · Journal
Loan Trusts and Discounted Gift Trusts in US Eyes
Two standard UK inheritance tax plans read through the US foreign trust rules: the settlor's nationality decides everything, and the discount does not travel.
Two standard UK inheritance tax plans read through the US foreign trust rules: the settlor's nationality decides everything, and the discount does not travel.
A UK loan trust or discounted gift trust is, almost always, a foreign trust for US purposes, and the US analysis turns on one question the UK literature never asks: who the settlor is. Where the settlor is a US person, the arrangement is likely to be a US-owned foreign trust reportable on Forms 3520 and 3520-A. Where the settlor is British and only a beneficiary is American, the same plan is usually a foreign non-grantor trust, and the tax lands on the beneficiary instead, years later.
Neither answer appears in the life-office literature these products are sold on. This article joins the two halves.
Both are sold by UK life offices, both are almost always written over a single-premium investment bond, and both exist to reduce inheritance tax without the settlor giving up all access to the money. They go about it in opposite ways.
In a loan trust, the settlor makes no gift at all. They lend a sum to the trustees, interest-free and repayable on demand, and the trustees invest it. The outstanding loan stays in the settlor's estate and can be called back; everything earned above the loan sits outside the estate from day one. There is no seven-year clock to survive, because nothing has been given away. The trade-offs are that estate reduction is slow and depends entirely on growth, and that repayments taken but not spent pile back up in the estate.
In a discounted gift trust, the settlor does make a gift, but carves out a right to predetermined withdrawals for life before making it. HMRC's own manual describes these schemes as arrangements in which "a set of rights are retained by the transferor, usually the right to predetermined withdrawals", so that the value transferred "is often less than the single premium paid" — the difference being what everyone calls the discount. The discount is outside the estate immediately. The rest of the gift still needs seven years. And because the retained rights are defined before the gift rather than taken out of it afterwards, HMRC accepts that where those rights are "sufficiently clearly defined", the gift with reservation provisions "will not be in point".
The discount depends on the settlor's age and health, so a discounted gift trust is usually underwritten and may be poor value for an impaired life; a loan trust needs no underwriting at all. That is the whole of the conventional comparison, and for an American it is the wrong comparison.
A trust is foreign for US purposes unless a US court can exercise primary supervision over its administration and US persons control all substantial decisions — and a plan written with a UK life office, UK trustees and UK governing law fails both limbs comfortably. From there the road forks.
Section 679 is the live provision. A US person who directly or indirectly transfers property to a foreign trust is treated as the owner of the portion attributable to that property if, for that year, there is a US beneficiary of any portion of the trust. The statute adds a presumption that bites hard: the IRS may treat the trust as having a US beneficiary unless the transferor demonstrates that no part of the income or corpus could be paid to or for the benefit of a US person, including on termination. Most UK family trusts, with their wide discretionary classes, cannot demonstrate that.
The result is a grantor trust: the settlor pays US tax on the trust's income and gains annually, whether or not anything is distributed. Our longer treatment of that test is in Is a settlor-interested UK trust a US grantor trust?
Two refinements matter here. There is an exception for transfers in exchange for consideration of at least the fair market value of the transferred property — but section 679(a)(3) then disregards, in making that comparison, obligations of the grantor, the beneficiaries or persons related to them, except as the regulations allow. The regulations allow only a narrowly defined "qualified obligation", which has to have a fixed term, a market-related yield and annual reporting by the US person. An interest-free promise repayable on demand has none of those features.
Separately, a non-US settlor who transfers to a foreign trust and then becomes a US resident is caught retrospectively: the five-year section 679(a)(4) pre-immigration look-back treats the transfer as made on the residency starting date. A British client who sets up a loan trust and moves to New York three years later has not escaped anything.
Here section 672(f) does the work, and it mostly switches the grantor rules off. Its general rule is that the grantor trust subpart applies only to the extent it results in an amount being currently taken into account in computing the income of a US citizen or resident or a domestic corporation. A British settlor is none of those, so the trust is not a grantor trust as to them — unless one of two exceptions applies: the grantor can revest the trust property in themselves alone, or the only amounts distributable during the grantor's lifetime are distributable to the grantor or the grantor's spouse.
That second exception is where the discounted gift trust becomes genuinely interesting. The product is built around a stream reserved to the settlor and nobody else. Whether that makes the relevant portion a foreign grantor trust in US eyes turns on whether anything at all can be appointed out to the residual beneficiaries while the settlor is alive — and many discretionary versions can do exactly that. It is a drafting question, not a product question, settled by reading the deed.
The IRS's own list of events that require a Form 3520 includes, in terms, a US person who "creates or transfers money or property to a foreign trust or makes a loan to a foreign trust". The defining act of a UK loan trust is a loan to a trust. If the lender is a US person and the trust is foreign, the filing obligation is on the face of the guidance.
The traffic runs the other way too. Where a foreign trust lends cash or marketable securities, or permits the use of trust property, to a US grantor or beneficiary, section 643(i) treats the amount of the loan or the value of that use as a distribution. Trustees who try to give an American beneficiary access by way of an informal loan have made a taxable distribution instead.
A US owner must also ensure the trust files a Form 3520-A and furnishes the annual statements — see Form 3520-A and who the US thinks owns the trust, and the Form 3520 instructions for the parts and deadlines. The penalties under section 6677 are not nominal: the greater of $10,000 or 35% of the gross reportable amount for a failure to report a transfer to, or a distribution from, a foreign trust, and the greater of $10,000 or 5% of the value of the portion treated as owned for a US-owner failure. A continuation penalty of $10,000 for each 30-day period runs once the IRS has mailed notice and 90 days have passed. Reasonable cause, shown rather than asserted, defeats the lot.
The discount is a UK inheritance tax valuation outcome, produced by valuing the settlor's retained rights on an actuarial basis and deducting them from the premium. It does not reduce anything on the American side. It is not a reduction in the amount transferred for US gift tax measurement, it does not shrink the portion treated as owned under section 679, and it has no effect on whether a Form 3520 threshold is crossed. A client told their gift has been "discounted by half" has been told something true about one country only.
The same applies to the seven-year rule. Surviving seven years removes the gift from the UK estate; it changes nothing about US grantor status, which is tested year by year on the facts of ownership.
Nearly all of these plans are written over a non-US life office bond, and that wrapper has its own US problems independent of the trust. A foreign policy is taxed as life insurance for US purposes only if it satisfies the US statutory definition of a life insurance contract; most UK investment bonds are investment products with a token life element and do not. If the wrapper fails, the owner is looking through it at the underlying funds, which are typically passive foreign investment companies with their own reporting and a punitive default regime. There is also a federal excise tax on premiums paid to a foreign insurer, which is a separate charge that survives even a wrapper that does qualify. We treat all of this at length in Offshore investment bonds and the US citizen problem.
A US angle does not suspend the UK regime. Where the discretionary version is used, the settlement is relevant property. A chargeable lifetime transfer above the available nil-rate band bears the 20% entry rate under IHTA 1984 s.7(2). Ten-year anniversary charges follow, at a computed rate that is three tenths of the lifetime rate and cannot exceed 6%; our note on what that means for an American beneficiary is at the ten-year anniversary charge with a US beneficiary. Exit charges are a fraction of that rate expressed in fortieths, one fortieth for each complete successive quarter, a quarter being three months.
Since 6 April 2025 the connecting factor for UK inheritance tax is long-term UK residence — UK resident for at least 10 of the previous 20 tax years — rather than domicile, which changes who these products help and for how long.
If the trust is a grantor trust as to a US person, distributions to that person are generally not a second taxable event, because the income has already been taxed to the owner. A foreign non-grantor trust works differently: a distribution carries out current income first, and amounts paid out of income accumulated in earlier years are accumulation distributions, taxed under the throwback rules, which rebuild the year the income arose and add an interest charge for the delay. So an American beneficiary of a long-running UK trust can receive a payment taxed far more heavily than the same money would have been had it been distributed when earned. We set out the inherited case in A UK will trust is not a grantor trust, and the restructuring options in varying or decanting a UK trust when a beneficiary is American.
Every position of this kind that we take is reviewed and signed by a licensed professional — a CPA or Enrolled Agent on the US side and an ACCA-qualified accountant on the UK side — before it goes anywhere near a filing. If you hold one of these trusts, or are being recommended one, you can book a consultation, see what an engagement costs on our pricing page, or start with our calculators and the wider US-UK private client tax hub.
Nothing here is advice on your facts. Cross-border trust positions depend on the deed, and the deed has to be read.