Inheritance tax: Protecting your family business
Milestones in the life of a family business can present both opportunities and risks. Frederik Bjorn and Clare Hetherington of law firm Payne Hicks Beach look at ways to take advantage of the former whilst reducing the latter.
Why is it important to plan for your family business?
Without reliefs or exemptions, the Inheritance Tax (IHT) rate on a shareholder’s death is 40%. The risk is that IHT needs to be met from the business itself, which is tax inefficient and could lead to the breakup of the family business. A shareholder’s death can also bring non-tax concerns. The continuing success of the business may become vulnerable to financial immaturity on the part of the next generation, matrimonial issues or outside influence taking the business in an undesirable direction.
Tax relief
Business Property Relief (BPR) provides up to 100% IHT relief for shares in an unquoted trading company which have been in the same ownership for at least two years. A company is ‘Trading’ if its activities do not consist ‘Wholly or mainly’ (more than 50%) of dealing in land, buildings or shares or in the making or holding of investments.
What steps can a shareholder take to protect their family business?
There are three main succession planning options for family company shares:
1. Outright gift
Why choose outright gifting?
While an outright gift (during lifetime or on death) may have the virtue of simplicity, the result is to put value and control into the hands of the recipient without the benefit of any asset protection. For some businesses it will therefore not be an appropriate option.
What’s the catch?
For tax purposes, subject to certain exceptions, the gifted assets will only cease to form part of the deceased’s estate once seven years have elapsed since the gift and provided the donor does not retain any benefit in the asset gifted.
Further, the gift will be a deemed disposal at market value for Capital Gains Tax purposes, with holdover relief only available in limited circumstances.
2. A trust for business assets
If shares qualify for BPR, these can be settled on trust without an IHT charge either in lifetime or on death. The shares are placed under the control of trustees and typically held for the benefit of younger (and future) generations of the family.
Why choose a trust?
Tax: If shares are sold during the shareholder’s lifetime in return for cash, BPR is lost and that cash is immediately at risk of a 40% IHT charge on death.
A trust is a way to maximise BPR and mitigate future IHT charges. Provided shares qualify for BPR, they can be transferred into trust during the shareholder’s lifetime without the usual upfront 20% IHT charge. On a later sale of the business, the proceeds cease to enjoy BPR but also do not form part of the shareholder’s estate and thus fall outside the 40% death rate (provided certain conditions are met). The trust assets do not suffer 40% IHT on the death of a beneficiary; instead, the trustees pay IHT charges of up to 6% on the trust value every ten years and pro-rated 'exit' charges on distributions of capital.
Asset protection:Legal ownership of the trust assets sits with the trustees (of which the business owner can be one) and it is the trustees’ decision alone whether any beneficiary receives a benefit. This can be helpful if a beneficiary is facing a divorce, bankruptcy or pressure to part with funds.
What’s the catch?
A trust must be established before any binding contract for sale is made over the business assets; otherwise, IHT relief becomes unavailable.
The business owner (and their spouse) cannot benefit from the trust without adverse tax consequences. Careful thought is required before deciding how much to settle onto trust.
A transfer into trust is a disposal for Capital Gains Tax purposes, albeit holdover relief can be available if certain conditions are met.
3. A family investment company (FIC)
Unlike a trust, a FIC is generally incorporated after the sale of a business and designed so that the business owners can benefit from the structure.
The business owner (and spouse) are typically appointed as directors and loan some or all of the business sale proceeds to the FIC.
Why incorporate a FIC?
Separation of control and economic benefit: A FIC usually has different share classes which separate voting rights from dividends rights. The business owner can retain control via the voting shares (and directorship), while the next generation can be gifted the shares with dividend rights so as to pass value on during the owner’s lifetime. The benefit of those shares can be restricted and released over time as the next generation becomes financially mature, thus providing an effective layer of asset protection.
Tax: There are various options for tax efficient investment and growth within the FIC corporate structure.
What’s the catch?
The terms of any loan to the FIC must be carefully drafted to ensure any future repayment is treated as such and does not inadvertently trigger a tax charge (as a dividend).
There is a risk of two layers of taxation on extracting funds, but this is often outweighed if the FIC is viewed as a long-term vehicle and funds are allowed to accumulate within the structure.
