Owner managed businesses : tax-efficient wills for company directors

Unquoted shares can enjoy up to 100% relief from Inheritance Tax (IHT).  Owner-directors of private companies should review their wills to ensure that valuable tax planning opportunities can be exploited and potential difficulties are avoided.

What is Business Relief (BR) and how is it applicable?

In the IHT legislation, “relevant business property” comprising “any unquoted shares in a company” qualifies for 100% relief (in effect, total exemption) after two years of ownership.  However, there are a number of important points to watch:

• BR is only applicable to trading as opposed to investment companies. No relief is given if the business carried on by the company “consists wholly or mainly of … dealing in securities, stocks or shares, land or buildings or making or holding investments”. However, the wholly or mainly test provides an opportunity to secure IHT relief for business assets brought into the company which might otherwise be non-relievable outside it, provided that the company’s business is predominantly of a trading nature and that no ‘excepted assets’ are involved.
• Relief will be lost to the extent that part of the share value is attributable to ‘excepted assets’, meaning assets owned by the company which are either used mostly for personal rather than business purposes or are surplus to business needs. A high level of cash may be a problem in this context, unless convincing evidence of its requirement for future business purposes can be produced.
• BR will also be denied if, at the time of the director’s death, his or her shareholding is subject to a binding contract of sale. This will include the situation where shareholders have entered into an agreement whereby the surviving directors are obliged to purchase the shares of a deceased director.  Where there is doubt on this issue, directors should review the memorandum and articles of association of their company, and any shareholder agreements.  A workable alternative which avoids this problem involves the use of cross-options.
• As far as possible, the benefit of BR should not be diminished unnecessarily by secured debt. In the case of a company shareholding, therefore, borrowings should be secured on the shareholder’s other (unrelieved) assets rather than on the shares themselves.
• Where an asset (such as a building) used in the company’s business is owned by a director personally, BR at 50% will apply to it, and then only if the director has control of the company (taking account of shares held by a spouse). For the asset to be sheltered by BR at 100% regardless of control, steps could be taken to bring it within the ownership of the company, but the Capital Gains Tax (CGT) and Stamp Duty Land Tax (SDLT) implications would need to be considered carefully.

How does BR impact your will?

BR is too valuable to waste.  So directors should avoid the following in their wills:

• Making a specific gift of shares to a spouse who will benefit from IHT exemption in any event. If the spouse subsequently sells the shares, the unrelievable proceeds will form part of his or her estate subject to IHT at 40% or,
• Dividing their estate between a mixture of IHT-exempt and non-exempt beneficiaries – for example, leaving a legacy to a spouse and the residue to children. If the shares are not dealt with separately, part of any BR will be allocated to the legacy and the IHT position for the residuary beneficiaries will be worse than it could have been.

BR may operate on a will to produce unforeseen and unintended results. For example, where the will gives a nil rate band legacy to children according to a formula (say, the maximum amount payable without IHT being assessed), with residue going to a spouse, and the estate includes relievable company shares, BR will have an affect on the formula so that the children receive more than simply an amount equivalent to the IHT nil rate allowance.

The best approach is for the will to deal with company shares specifically, leaving them to beneficiaries who are not exempt from IHT, in other words not to a spouse.  In a family context the obvious choice will be children, but a direct gift may be problematic for a number of reasons.  To begin with, such a course may leave a spouse insufficiently provided for.  In addition, an outright gift to a number of children may be inappropriate because of different degrees of involvement in the business and the implications for future management.  Finally, in many cases the extent of BR may not be certain, either because of the hybrid nature of the business or the possible existence of ‘excepted assets’.

Using a discretionary will trust

Will trusts are a less drastic means of preventing the waste of BR and addressing these problems.  A discretionary trust has the advantage of enormous flexibility, since the chosen trustees (usually the executors named in the will, who may include a spouse) can be given complete discretion over the manner in which company shares, and any proceeds of sale, are applied for the benefit of a broad class of family beneficiaries.

There are clear advantages to this type of arrangement:

• A surviving spouse will not be cut out financially, since he or she will feature among the potential beneficiaries
• Loss of control will be avoided, because voting rights attached to the shares will be exercisable by the trustees
• BR will be tested if share values are such that IHT could be an issue. Wills should avoid using a nil rate formula which discourages examination by HMRC and makes the availability of relief uncertain
• Room for manoeuvre will be preserved in that, if BR is not available or only on a restricted basis, the trustees can redirect shares for the benefit of a widow or widower within two years of the death and secure IHT spouse exemption retrospectively.
• Where BR-relievable shares are held within a discretionary will trust, a variety of estate planning opportunities can arise.

What about IHT mitigation?

Shares may remain in the trust for the time being and can subsequently be allocated to children or other family members as and when the trustees consider it appropriate.  In either case, the ten yearly and exit charges for IHT usually associated with discretionary trusts will not apply even if the overall trust value is well in excess of the nil rate band, so long as the BR conditions continue to be satisfied.  Moreover, a distribution of shares by trustees compares favourably with gifts by a surviving spouse, since in the latter case IHT relief may be lost if the donor dies within seven years and in the meantime the donees have disposed of the shares.

Where the intention is to sell the shares or wind up the company, any proceeds retained in the trust will benefit from a more favourable IHT environment than would be the case if they were held by a surviving spouse, who did not wish to maintain involvement in the business.  This is because the maximum IHT rate applicable to discretionary trusts stands at 6%, as compared to 40% for an individual.  Since the trust fund can be administered for the benefit of the survivor without forming part of his or her taxable estate, this may facilitate gifts of unrelieved assets in the direct ownership of the survivor, to reduce any residual IHT exposure.

On the other hand, where a surviving spouse intends to continue the business, he or she may consider acquiring some or all of the shares from the trust at full market value, purchased from unrelievable monies which have passed to the spouse directly.  After the qualifying holding period, and assuming the other conditions are met, the purchased shares will be eligible for BR in his or her hands, and the value of his or her estate for IHT purposes will be further reduced by the purchase monies now hold by the trustees.  In addition, if the trust’s creation by the predeceasing spouse’s will was itself covered by BR, the survivor’s estate may still qualify for a doubled IHT allowance (currently worth £650,000) under the transferable nil rate band rules.

As with any planning involving trusts, the choice of executors and trustees is all important.  Furthermore, when assessing the merits of any particular course of action, the trustees need to have regard to the potential implications of other taxes such as CGT and SDLT.

The importance of reviewing your will and BR

The directors of owner-managed incorporated businesses should review their wills in tandem with their company’s memorandum and articles of association and any shareholders agreements, to ensure that BR can be exploited effectively in the interests of their intended beneficiaries and provide an appropriate framework for succession.

Of course, there is no guarantee that BR will continue in its current form, and there may be other reasons for wishing to take advantage of the existing generous rates of relief.  This will be the case where:

• It is likely that the company will be sold before the shareholder’s death
• Changes in the nature of the business may restrict the future availability of BR
• Circumstances require other family members (who may already have a role in the company) to be given a stake in the business.