Want to pass your business down to the next generation? Plan ahead to cut your tax liability.
If you thought inheritance tax planning was difficult enough when only a family home was involved, think again. When families own businesses, the complexities are far greater.
Almost half of British small business owners hope to pass on their business to their children, according to research from Close Brothers Asset Management.
But although people are considering succession plans, many are not aware of the tax implications.
There are three million family businesses in Britain, according to the Institute for Family Business, and each year some 100,000 family firms are thought to pass from one generation to the next.
Amalia Brightley-Gillott, the editor at Family Business Place, which promotes family businesses, said: “I don’t think anyone starts a business planning to pass it on to their children, but as it grows you want continuity and customers to know that the same values and family will be involved.”
Gary Heynes, a partner at Baker Tilly, the accountancy firm, said: “The starting point is looking at the business entity, how the business is structured, as that changes the rules slightly.”
Trading businesses qualify for 100pc relief from inheritance tax under a system called business property relief. To qualify, the business must be an unlisted company – or one listed on the junior Alternative Investment Market (Aim) – and must have been trading for at least two years.
A similar relief for agricultural property and land, agricultural property relief, covers farmland and farming businesses, but it has to be a trading farm to qualify – keeping chickens in your garden is unlikely to pass muster with the taxman.
“This means that if you fully own a company and you were to die, the shares could be left to the next generation entirely free of tax, and that is incredibly valuable,” said Mr Heynes. “A lot of people miss out because they don’t realise the criteria; they have too much in investment, for example.”
A non-trading company, such as an investment company or a company that receives property rental income, does not qualify for the relief.
Patrick Haines, regional head of advice at Close Brothers Asset Management, said: “Tax planning is intrinsic to the success of passing on a business, and understanding the tax implications involved in operating and passing on a business can help protect wealth for retirement – in addition to the use of tax-efficient personal savings.”
Harvey Bowden and his wife, Ann, are preparing to hand their successful water softener business, Harvey Water Softeners, based in Woking, Surrey, to their youngest son, Casey.
“We thought about what would happen to the business constantly as the years went by, but none of my children expressed an interest until about four years ago,” Mr Bowden said. “We always had the idea that we would either sell or pass the business on.”
Casey Bowden, now 32, joined the business in 2004 and became a director three years ago. He currently owns 2.5pc of the shares and the family have decided to grow this share to 49pc through his bonus over the next decade. The remainder he will inherit on his father’s death. His two elder brothers will each own 2.5pc of the business.
Harvey Bowden said: “If my children hadn’t been keen, I would have sold – it gets to the point when the strain outweighs the reward. Now Casey has started to take the strain.”
Harvey Water Softeners also owns rental properties, so as part of the succession plan the family is splitting out the property arm, which will be run by son Roy, aged 33, so the water softener company qualifies for business property relief.
Patricia Mock, a tax partner at Deloitte, said business owners should also be aware that business property relief might not apply if they die within seven years of gifting the company to their children. If the children have sold the business during that time, for example, the windfall could be subject to inheritance tax. Additionally, business owners can’t put additional assets into the company, known as excepted assets, to try to get around inheritance tax.
Capital gains tax (CGT) is another interesting factor because gifting business assets means they can be exempt from the tax. If a parent has built a business worth £10m, for example, they could pass it down to their child and pay no capital gains on the value. However, the tax is only deferred. If in this example the child later sells the shares for £20m, they would pay capital gains tax on the full £20m gain.
That’s important because of entrepreneur’s relief. Capital gains tax is usually 28pc, but there is a special 10pc rate which applies to businesses up to a value of £10m. For a business worth £10m, this could mean a total saving of £1.8m if the whole business changes ownership.
In some circumstances, said Ms Mock, this means it might be better not to defer capital gains. Again to use the example above, it would mean the parent and child each pays 10pc on their £10m gain, instead of the child paying 10pc CGT on the first £10m and the full 28pc rate on the rest.
“Although gains can be held over, it is not always the best answer,” she said. “It is also worth keeping track of share ownerships fragmented around families in this situation – you need to hold 5pc for at least a year to qualify for entrepreneur’s relief and you need to work for the company, as an employee or an office holder.”
Parents stepping away from the business should think about whether the business should pay into their pension fund, how they will manage proceeds from a sale during their retirement and whether they could retain shares in the business to pay a dividend.
Mr Heynes said: “There is no simple answer. Individuals must think about where the business will go on their retirement and who will benefit from its value. When you have made those more emotional decisions, discuss with your accountant about how to manage the process.”