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Wealth protection using discretionary trusts

Iris Wuenschmann-Lyall is a consultant with Toby Harris Tax Consultancy.

Setting up a discretionary trust can help reduce an inheritance tax bill. But, as Iris Wuenschmann-Lyall explains, retiring family businesses owners can also retain a good measure of control over their enterprise

The benefit of discretionary trusts in passing wealth down the generations and minimising inheritance tax has long been recognised by many of the wealthiest entrepreneurial families. However there are still many family owned businesses that rely on business property and agricultural property relief for inheritance tax when planning for succession of their business activities. Recent suggestions by a fiscal think tank to increase the upper band of inheritance tax to 50% should ring alarm bells with everyone who has assets above £750,000. While drastic changes to the inheritance tax legislation are unlikely to happen before the next election, there seems to be an increasing trend to penalise high net worth individuals. Succession planning, whether for tax reasons, protecting assets from spendthrift children or planning for difficult family circumstances, should be an important part of the agenda for family owned businesses and it may now be time to consider using discretionary trusts to provide for unpredictable changes in the fiscal and business environment.

What tax is payable when the trust is set up?
Generally lifetime transfers of the first £263,000 (at current rates) into a discretionary trust are free from inheritance tax, while transfers above this rate incur an inheritance tax charge of 20%. However if assets qualify for business and/or agricultural property relief for inheritance tax, for example shares in a private trading company, a charge to inheritance tax on the transfer into a discretionary trust can be avoided altogether. In addition such transfers qualify for holdover relief for capital gains tax, which is available whether or not the shares in the family business qualify for business property relief. The tax legislation currently favours business owners, but a trust may not suit every family situation and it is therefore essential that advice is sought from a trust and tax expert.

Discretionary trusts and the business environment
The future is uncertain, even more so for companies whose business activities have to constantly adapt to changes in the business environment. Currently many shareholders in family owned companies rely on business property relief for inheritance tax to plan for succession. This, of course, may limit the amount of inheritance tax paid on death, assuming that there is no new legislation, which restricts the reliefs available to shareholders. But it does not take into account changes in the business activity of the company, a potential sale of the company or a more stringent inheritance tax regime.

A company which currently qualifies for business property relief for inheritance tax may have to change its strategic direction. The directors of the company may decide to diversify or change the emphasis of its business activities by increasing their property portfolio. Unbeknown to them, the company now does not qualify as a trading company but will be viewed as an investment company by the Inland Revenue. As shares in investment companies do not qualify for business property relief, the death of a shareholder will result in a 40% charge of inheritance tax above £263,000 (at current rates) on the value of those shares. In a family owned business, it will be the other remaining family members who will now be left with the problem of raising sufficient funds to pay the tax.

A similar problem may arise where a family company has been approached by a potential buyer. The offer is very attractive and the shareholders agree to a sale. Once the shares have been sold, business property relief for inheritance tax ceases to be available on the sale proceeds and inheritance tax at 40% above the nil rate band will become payable on the death of a former shareholder, thereby substantially reducing the family's wealth. 

With a little tax planning the inheritance tax charge could have been avoided in both situations, if the shares had been passed into a discretionary trust while the company still qualified as a trading company. The timing of the sale of the company or the change in trading activity however is important and it will be necessary to wait seven years from transfer of the shares into the trust – otherwise the Inland Revenue will levy a charge to inheritance tax on these shares and retrospectively treat these shares as if business property relief had never been available.

Once the shares within a discretionary trust no longer qualify for business or agricultural property relief, they may become subject to an inheritance tax charge every ten years or when assets leave the trust. But as the maximum charge is 6% on the value of the trust assets or on the value of the assets leaving the trust, it is substantially lower than a 40% charge on the death of a shareholder.

Succession planning and family difficulties
Apart from tax, there are other situations, which may make the use of discretionary trusts an attractive option. Let's assume the scenario of a 60-year old business owner who is considering reducing his or her working hours and planning to enjoy retirement. He or she would very much like to pass some of the responsibility to the children, but is concerned that he may lose control of the business. There may be three children, however one child is unlucky in his or her business ventures and usually teeters on the brink of financial disaster. The second child works very hard in the family business and contributes greatly to its success, while the remaining child lives overseas and only visits every two years. The business owner would like to pass his or her shares down the generation to the children, but he may not only be faced with a substantial capital gains tax charge, as some of the assets in the business do not qualify as business assets, but also with a moral dilemma. Does he or she compensate the child, who works in the company, for the time he devotes himself to the business and give him a larger shareholding? Is it wise to pass shares to someone who may face bankruptcy? And what about the third child who may not want to have the burden of travelling to the UK for shareholders' meetings?

In addition, the business owner is concerned that once he or she has passed the shares to the children, the ownership of the company may become more fragmented which may slow down the decision making process and increase the risk that the shares may be sold outside the family. He would like to retain some control over the company, but he is quite content to leave the day-to-day decisions to the next generation. Furthermore, he may be worried that shares which have been passed down the generations are at risk of becoming subject to bankruptcy proceedings or a divorce settlement and he is aware that the remaining shareholders, often the parents, will have to take action to safeguard these shares. The necessary resources to do this may be hard to find and may prejudice any development plans for the family business. Then there are the added complexities when family units extend and provisions may have to be made for second families and stepchildren.

Solutions to problems
A discretionary trust may be able to overcome some of the difficulties mentioned above, and will leave the ultimate destination of the shares at the discretion of the trustees, who are then able to make decisions as and when problems arise. The majority shareholders, often the parents, can be appointed as trustees, which would give them control over the family company without having to participate on a day-to-day basis. The voting power of the shares will remain with the trustees whose appointment can be controlled during the settlors' lifetimes. The trustees will have discretion over who benefits from the trust, whether it is paying school fees for the grandchildren, helping children to purchase a property or benefiting stepchildren. In addition the shares are much less likely to form part of a potential divorce settlement or bankruptcy, therefore preserving the family's wealth.

It is however important to bear in mind that a settlor cannot benefit from the trust without losing the inheritance tax benefits. A shareholder may therefore have to consider retaining shares in his or her own name to obtain dividends to ensure that he is left with sufficient funds for his or her financial needs. Sometimes, depending on the dividend stream, this may not be possible and it is therefore vital to consider all factors before passing shares into discretionary trusts. 

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