Inheritance tax: protecting your family business
The 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 are looking for ways to leverage the former while reducing the latter.
Why is planning important for your family business?
Without allowances or exemptions, the rate of inheritance tax (IHT) on the death of a shareholder is 40%. The risk is that the IHT has to be covered by the business itself, which is tax inefficient and could lead to the breakup of the family business. The death of a shareholder may also give rise to non-tax concerns. The continued success of the business may become vulnerable to financial immaturity on the part of the next generation, marital problems, or outside influence pulling the business in an undesirable direction.
Business Property Relief (BPR) provides up to 100% IHT relief for shares of an unlisted commercial company that have been owned by the same owner for at least two years. A company is “commercial” if its activities do not consist “wholly or principally” (more than 50%) in dealing in land, buildings or shares or in making or holding investments.
What steps can a shareholder take to protect their family business?
There are three main estate planning options for shares in a family business:
1. Outright Donation
Why choose pure and simple donation?
While an outright gift (live or upon death) may have the virtue of simplicity, the result is to put the value and control in the hands of the recipient without the benefit of any asset protection. For some companies, this will therefore not be an appropriate option.
What’s the catch?
For tax purposes, subject to certain exceptions, the donated property will not cease to form part of the deceased’s estate until seven years have elapsed since the gift. and provided that the donor retains no advantage over the donated property.
In addition, the gift will be a deemed disposal at market value for capital gains tax purposes, with withholding relief only available in limited circumstances.
2. A trust for business assets
If the shares are BPR eligible, they can be settled in trust without IHT fees, either for life or on death. Shares are placed under the control of trustees and generally 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 exchange for cash, BPR is lost and this sum is immediately exposed to the risk of a 40% IHT charge in the event of death.
A trust is a way to maximize BPR and mitigate future IHT charges. Provided the shares are BPR eligible, they can be transferred into trust during the shareholder’s lifetime without the usual upfront 20% IHT charge. Upon a subsequent sale of the business, the proceeds cease to benefit BPR but also do not form part of the shareholder’s estate and therefore fall outside the 40% death rate (subject to certain conditions are fulfilled). Trust assets do not incur 40% IHT on the death of a beneficiary; instead, trustees pay an IHT fee of up to 6% on the value of the trust every ten years and a pro-rated “exit” fee on capital distributions.
Asset Protection: Legal ownership of trust assets rests with the trustees (of which the business owner may be one) and it is up to them alone to decide whether a beneficiary receives a benefit. This can be useful if a recipient is facing divorce, bankruptcy, or pressure to part with funds.
What’s the catch?
A trust must be established before any binding contract of sale is entered into over the assets of the business; otherwise, IHT relief becomes unavailable.
The business owner (and spouse) cannot benefit from the trust without adverse tax consequences. Careful consideration is needed before deciding how much to give to the trust.
A transfer into trust is an assignment for capital gains tax purposes, although withholding relief may be available if certain conditions are met.
3. A family investment company (FIC)
Unlike a trust, an FIC is usually formed after a business is sold and designed in such a way that business owners can benefit from the structure.
The business owner (and his or her spouse) are usually appointed directors and lend some or all of the proceeds from the sale of the business to the FIC.
Why set up an FIC?
Separation of control and economic benefits: An FIC usually has different classes of shares that separate voting rights from dividend rights. The business owner can retain control through the voting shares (and directorship), while the next generation can receive the dividend shares to pass on the value during the owner’s lifetime. The benefit of these actions can be limited and released over time as the next generation becomes financially mature, 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 FIC loan should be carefully drafted to ensure that any future repayments are treated as such and do not inadvertently trigger a tax charge (such as a dividend).
There is a risk of double taxation on the extraction of funds, but this is often offset if the FIC is considered a long-term vehicle and the funds are allowed to accumulate within the structure.