What happens when the deceased owed, or was owed, money? Ruth Pyatt explains.
A promissory note is, in its most basic form, a written statement containing an unconditional promise by one party to pay a definite sum of money to another party.
Often, a promissory note is used to set out the terms of a debtor/creditor relationship, and such documents are commonly drawn up, with or without legal assistance, when an individual borrows from a family member or friend.
According to the StepChange Debt Charity, 28 per cent of those seeking advice on managing debts owe more than £4,000 to family and friends.
A personal representative (an executor or administrator of a deceased person’s estate) often needs to take advice on the position of the estate, where the deceased has either been a debtor or creditor of a family member or friend and the debt, or part of it, remains outstanding as at the date of death.
If debtor/creditor relationships have been entered into, the initial difficulty can be proving the terms of the agreement between the parties. In the ideal situation, a personal representative can evidence the agreement by promissory note, or ‘I owe you’. How the personal representative should then proceed depends on whether the deceased was the debtor or creditor.
The deceased was owed money at the date of death (a creditor)
The debt is an asset of the estate and must be included for probate and inheritance tax (IHT) purposes.
The starting point for the personal representative is an assumption that the debt will be repaid in full. It is important to note that debts written-off during the lifetime (often on the deathbed) of the deceased will be regarded, for tax purposes, as a potentially exempt transfer (PET), or an immediately chargeable transfer at the time of writing off and may therefore still have to be included in the estate.
Also, in law and in equity, the release of a debt that is made voluntarily and without consideration must be made by a deed, otherwise it is void. If an IHT400 form is being completed, HMRC will require formal written evidence of the loan. Also required will be evidence of any loan that has been written-off. If the personal representative wishes to submit a figure for the loan, other than the full value of capital and interest outstanding at the date of death (because the personal representative believes that it is impossible, or not reasonably possible, for the debt to be repaid), they will need to give a full explanation.
Tax planning arrangements involving loans may also have to be accounted for, such as a loan trust, whereby money is lent, usually to a family member or trust, which then invests. In such schemes, the idea is that growth of the money loaned is outside the lender’s estate; but the original loan may or may not be repayable to the estate, depending on whether the loan had been in repayment during lifetime.
One other point that a personal representative should not overlook is that if the deceased was charging interest on the loan, this would have been additional income liable to tax and will have to be accounted for in any tax returns outstanding at the date of death.
The deceased was the debtor and had unpaid loans at the date of death
Debts owed by the deceased at the date of death are generally deductible for the purposes of IHT and for obtaining probate. If an IHT400 form is being completed, the personal representative will have to give copies of any written loan agreements and provide full details to show that the loan should be allowable as a deduction, such as the date of the loan, relationship of the creditor and the deceased, and details of how the deceased used the funds. However, particularly in the context of promissory notes, there are important and complex conditions concerning what the money the deceased borrowed was used for, and whether the debt is actually repaid from the estate.
‘Neither a borrower nor a lender be…’
These conditions on the deductibility of debts were mainly introduced by the Finance Act 2013 to combat ‘artificial’ debt arrangements and IHT avoidance schemes (which would include, in the simplest cases, an ‘I owe you’ for monies never actually received). This is an area in which personal representatives need to be particularly wary.
Except in very limited circumstances, if a personal representative is aware that a debt is not going to be repaid or is only partly to be repaid (for example, as in the case of the ‘I owe you’ for monies never received or, as another straightforward example, because the debt has been waived or partly waived), the debt (or only part of the debt) should not be included for IHT and probate purposes. Also, if such a debt is included as a deduction and not subsequently repaid, HMRC needs to be told.
What if the deceased had borrowed and then given the money away? It is possible to conceive of a situation where this might happen – parents who have limited liquid assets but wish to assist their children with, for example, a deposit for a house. In this case, the personal representative will have to account for a debt which is deductible and a PET (or immediately chargeable transfer if the gift was into trust), which may be subject to additional tax on death.
‘He that dies pays all debts…’
One further note is that a personal representative needs to be particularly aware of promissory notes in the case of insolvent estates. For example, while most ordinary unsecured debts rank equally, a debt to a spouse or civil partner is a deferred debt and should not be paid until all other debts have been paid in full.
(Author: Ruth Pyatt)