Why is it important to plan for your family business?
In the absence of any reliefs or exemptions, the Inheritance Tax (IHT) rate on the death of a shareholder in a family company is 40%. The risk is that the funds needed to meet the IHT have to be found from the business itself, which is both tax inefficient and could lead to the breakup of the family business.
There may also be a concern about the ownership and control of the family business following the death of one or more of the main shareholders, whether as a result of a lack of financial maturity on the part of the next generation or due to matrimonial issues which may arise, for example.
Is tax relief on IHT available for businesses?
IHT relief is available for shares in certain businesses. Notably, if the shares are in an unquoted trading company and have been in the same ownership for at least two years, Business Property Relief (BPR) can provide up to 100% relief from IHT.
Provided the two year ownership condition is met, an interest in a partnership or a business run by a sole trader can also enjoy up to 100% relief from IHT.
What is a trading company for the purposes of BPR?
A company is ‘trading’ for these purposes provided its activities do not consist ‘wholly or mainly’ (i.e. more than 50%) of dealing in land, buildings or shares or in the making or holding of investments.
What options does the major shareholder of a family business have?
There are typically three main succession planning options for family company shares: an outright gift (whether during a lifetime or on death), a transfer into a trust or a company holding structure. The options have to be analysed based on each family business’ particular circumstances but looking at the trust or company holding option there are considerations to take into account for either route:
A trust for business assets
A trust can be created in a lifetime or on death, and involves assets being placed under the control of trustees for the benefit of one or more beneficiaries.
What are the advantages of a trust?
If shares qualify for BPR on death, they can be left in a flexible trust through the deceased’s Will with no adverse IHT implications. However, if the shares are sold during the shareholder’s lifetime and receive cash, that cash is immediately at risk of a 40% IHT charge on death.
One option to deal with this risk is for the shareholder to settle their shares onto trust for the benefit of their family, typically for younger (and future) generations.
This has advantages both from an IHT perspective and from an asset protection perspective:
Provided the assets qualify for BPR at the time of transfer into a trust, there is no charge to IHT at that point (whereas ordinarily, there is a 20% upfront IHT charge on settlement).
If the business is subsequently sold, the sale proceeds are held in trust. At that point, BPR ceases to be available, but the proceeds do not form part of the shareholder’s estate and therefore do not suffer a 40% IHT charge on the shareholder’s death. The trust assets also do not suffer a 40% IHT charge on the death of any beneficiary of the trust. Instead, the trustees pay periodic IHT charges of up to 6% on the trust value every ten years and pro-rated ‘exit’ charges on distributions of capital.
How does a trust protect assets?
A trust structure provides a layer of asset protection, most notably from certain family members. Legal ownership and control of the assets sit 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.
Are there any pitfalls to avoid with a trust?
- A trust for business assets must be put in place before any binding contract for sale is made over those assets; otherwise, the IHT relief becomes unavailable.
- The business owner (and their spouse) cannot be a trust beneficiary without triggering adverse tax consequences. Care must therefore be taken in deciding how much to settle onto the trust and how much is retained outside the structure.
- Qualification for BPR needs to be assessed and confirmed by an accountant before taking any steps.
A family investment company (FIC)
A FIC is a bespoke private company that can be used as an alternative to a trust. However, there are significant differences between the two structures in terms of their operation and tax perspective. A FIC is generally incorporated following the sale of a business, and the business owners can benefit from the structure.
What are the advantages of a FIC?
The main advantage of a FIC is that a structure can be put in place whereby control is separated from economic benefit so that shares can be transferred to the next generation by way of gifts, but the benefit of those shares (and any other economic rights) can be restricted and released over time as the next generation becomes more financially mature, for example.
Once the FIC holds funds, there are various tax efficient options for investment and growth within the corporate structure.
How does a FIC protect assets?
A common approach is for the business owner (and spouse) to be appointed as directors and to loan some or all of the proceeds of a business sale to a newly incorporated FIC.
A FIC typically has different classes of shares which separate the voting rights from the dividends rights. For example, ‘A’ shares could carry the voting rights and would be held by the parents, whilst ‘B’ shares could have the rights to dividends and would be held by the children. Further classes of shares can be created in future for different family members or to carry different rights.
This structure allows business owners to transfer material value into a structure for the benefit of their family whilst retaining control via their directorships and voting shares, thus providing an effective layer of asset protection for the next generation.
Are there any pitfalls to avoid with a FIC?
- Care needs to be taken regarding the terms of any loan to the FIC to ensure that any future repayment is treated as such and does not inadvertently trigger a tax charge (as a dividend).
- A FIC is likely to be most effective if it is viewed as a long term vehicle and funds are allowed to accumulate within the structure, otherwise there is a risk of two layers of taxation.
If you would like to discuss any of the issues raised, please do not hesitate to contact the authors or your usual Payne Hicks Beach contact.