Protecting and passing family wealth

Writing for Tax Journal, Associate Tax Director Sam Inkersole explores different ways of passing family wealth to the next generation and ultimately shielding it from inheritance tax (IHT).

These methods include pensions, gifts, family investment companies (FICs), growth shares and discretionary trusts.

Summary

Nothing is certain except death and taxes’ (Benjamin Franklin, 1789). The first part is true (for now), but the second is certainly a variable element if appropriate planning is undertaken. Adding to pension schemes and gifting assets away is a start, but planning can venture into Family Investment Companies, Offshore Bonds and Trusts. Although planning at the more complex end of the scale can appear straightforward, in reality it can be extremely complex, touching on several areas of taxation. The family situation and the ages of children also need to be considered to ensure the solution presented is appropriate.

During the recent election, Labour and the Conservatives could not have been more different in their views on IHT. In the run up to the General Election, the Conservative Chancellor described the tax as unfair and ‘profoundly anti-Conservative’, but there was no mention of their plans for IHT in their manifesto. Labour outlined that they would enhance the changes to the non-dom rules, which could bring more individuals into the IHT net, and have suggested tweaks to the current rules to reduce inheritance tax avoidance through the use of offshore trusts.

Rumours of imminent tax changes are also awash, with an article in The Telegraph (24 July 2024) titled ‘Labour “double death tax” could be higher than 50pc’ warning that Labour could be poised to introduce CGT on estates as well as IHT when someone passes away.

So what can be done within the current rules to pass wealth to the next generation and ultimately shield it from IHT? There are several different solutions, some of which are explored within this article at a high level. It is worth noting that each family’s case will be different, so there is no ‘one size fits all’ solution. Some families choose to do one specific piece of planning, whereas others choose an array of solutions.

Given the recent change in government, it’s worth noting that this article is written with current rules in mind. There may be changes to rates, thresholds and legislation which frustrate or close planning opportunities, but only time will tell.

Pensions

Pensions are always a starting point for IHT planning, given that they are outside of an individuals estate for IHT purposes.

For those who run an owner managed business, making corporate pension contributions are a fantastic way of getting cash out of a company and into the hands of the business owner. The company gets corporation tax relief on the contribution, subject to any pension spreading rules applying. The individual gets cash out of the company with no income tax implications, so long as the pension contribution thresholds are not breached (currently £60,000 per fiscal year but this amount is tapered where the individuals ‘threshold income’ exceeds £200,000 and the ‘adjusted income’ is also over £260,000).

Generally, the age at which the pension holder passes away determines in what form the pension pot is passed to the beneficiaries. If they pass away:

• after they are 75 years old, the amounts within the pension pass to the beneficiaries as a pension (it is then drawn as a pension in the future);
• before the age of 75 years old, it is possible to structure the amount within the pension so that they continue to grow in a tax-free environment, but the initial capital and any future increase in value can be drawn down tax-free.

As this is an article on passing wealth, and the pension pot usually remains untouched by those who are entering into more complex tax planning mechanisms, I haven’t outlined how pension draw downs work.

There are more aggressive pension arrangements available to wealthy individuals, such as Qualifying Non-UK Pension Schemes (as recently highlighted in The Guardian, ‘Super-rich being advised how to avoid Labour tax clampdown, undercover investigation suggests’, 26 July 2024). Such arrangements may become an easy target in the next Budget.

Giving assets away

There are three methods of giving assets away: (i) gifting away amounts which are in excess of regular income, referred to herein as gifts out of capital; (ii) gifts within the annual (6 April to 5 April) allowances; and (iii) gifting out of regular income.

Gifts out of capital

Cash or amounts held in ISAs can be given away with no CGT implications. The gift will be a Potentially Exempt Transfer (PET) for IHT purposes, so the donor must survive for a period of seven years from the date of gift in order to totally escape IHT being levied on the gift.

It is possible to give away other assets, such as properties or shares held in a general investment account, but the CGT implications of making the gift will need to be explored as the gift to an adult child is treated as a market value disposal for CGT purposes.

There is, however, risk when giving assets away to adult children. The most common quip I receive from parents is that they don’t trust their children to have large amounts of assets in their own name.

As such, gifts are usually made to assist in paying off university debts, put towards a deposit for a first home or a wedding celebration. The aim is to put the adult child on a safe financial footing when they are at the start of their adult lives, but not to give them so much that they either feel like they don’t have to work or squander it.

Gifts within the regular annual allowances

The table below outlines those gifts an individual can make on an annual basis, which do not fall within the IHT rules.

It is possible to combine allowances when making gifts to the same person. For example, if a child were to get married, the annual exemption and the wedding gift allowances can be combined in a single year to form an allowance of £8,000.

Gifts out of regular income

In addition to the gifts outlined above, where gifts are made out of regular income they do not fall within the scope of IHT. A gift is defined as being made out of regular income where: (i) the individual can afford the payments after meeting their usual living costs; and (ii) the payments are made from the individual’s regular monthly income.

There is no maximum to the quantum of the gifts made out of regular income. As such, utilising this gifting process can be a nice method for those with very high levels of income, but more frugal lifestyles, to give away cash which would have gone into a savings or investment account, so that it doesn’t become part of their estates for IHT purposes.

Family Investment Companies

Family Investment Companies (FICs) are a great IHT freezing method. Although they have a catchy name, in reality they are a normal corporate entity with a ‘funky’ shareholding structure. The main point of them is to pass the future growth in wealth to the next generation.

Generally, the parents will input funds into the company, through a loan or equity, and the adult children (and possibly a discretionary trust) will hold shares which will increase in value over time. There are several ways to structure a FIC and the ultimate structure will depend on the family’s circumstances.

Some key points to consider when setting up a FIC are:

• The type of entity to use: should the entity be a UK entity, would a corporate or a partnership work best for the family, is a limited or unlimited entity most appropriate?
• How the FIC will be funded: by loans (should they be interest bearing or not), normal shares or preference shares, bank lending against other family assets?
• What rights will the shares have: should they all have full rights, or should voting, economic and dividend rights be split between share classes?
• Who should hold shares: are any of the children under 18, what share classes with which rights should be held by each family member?
• The settlements legislation: does the method of funding the FIC or the passing of or subscribing for shares in the FIC lead to a charge under the settlements legislation?
• Has thought been given to future-proofing the FIC: is a Discretionary Trust required in the structure?
• Management of the FIC: who will the directors of the FIC be and will all family members be involved in decision making?
• Protections: are there sufficient provisions within the articles to protect the shares from leaving the family in the case of divorce or bankruptcy, are provision needed to outline what the FIC can invest in?
• How will the FIC be run? In addition to the provisions within the articles, is a shareholders’ agreement needed to ensure there is a ‘rule book’ to help run the FIC?

The taxation of gains and income arising on assets held within the FIC should be communicated with the client. The most tax efficient investments to hold in a FIC are (i) shares which are dividend yielding (as the dividend exemption rules should, in most cases, apply to the dividend income) and (ii) shares which will qualify for the Substantial Shareholding Exemption on their disposal (as there would be no corporation tax on the gain made on the shares).

It is always worth discussing possible investment strategies with the client and their IFA to ensure that they are aware of the tax implications of the proposed investments so that informed investment decisions can be made within the FIC.

Offshore bonds

Offshore bonds (OBs) are a product which are well used by independent financial advisers (IFAs), but they can sometimes be a bit of an enigma for those not working within financial advisory (and also for clients to whom they are recommended by their IFA!). For UK taxation purposes, OBs fall within the rules on ‘foreign policies of life insurance and foreign capital redemption policies’ under ITTOIA 2005 s 476. At a high level, OBs are a tax efficient investment wrapper which enable an individual to invest cash into the bond for medium to long term growth. The growth is usually tax-free (subject to withholding tax on dividends and received on the underlying investments), as the bond is usually issued by an offshore life company from jurisdiction which doesn’t levy tax on the bonds.

It is possible to set up an OB such that the growth in value of the investment falls outside of the individual’s estate for IHT purposes. An IFA would be able to help with this.

The normal term for an OB is 20 years, and each year the individual who initially funded the bond can draw down 5% of the principal with no tax implications for them. This 5% is a cumulative amount, and there is no requirement to draw down the amount each year.

For example, the individual could invest £500,000 initially into the bond. At the end of years 1 and 2, they do not draw down any funds. At the end of year 3, they want to draw down the maximum amount which they can. As no amounts were drawn down in years 1 and 2, at the end of year 3, 15% of the initial investment can be drawn down, totalling £75,000.

When the bond matures, all of the profits (regardless of whether they are from gains made on investments or income returns on investments) are taxed as interest at income tax rates on the individual. There are intricacies in relation to the taxation of this income and the application of the savings allowance and top slicing can lead to lower income tax liabilities arising than one may think. However, the fact that the income tax charge arises on the maturing of the OB means that there is a great amount of uncertainty around the rates of tax which will apply and reliefs available. The tax free roll up of income and gains made during the investment period needs to be weighed up against the uncertainty surrounding the effective rate of tax which will be paid on maturity.

It is possible to write segments of the OB into trust, either on entering into the OB or by assigning the segments once the OB has been created, so that the trustees of the trust are taxed on the growth in value of the bond segment(s), rather than the settlor. Both of these will be a PET for IHT purposes.

Compared to the FIC, the types of investments which can be held in an OB are somewhat limited. Care needs to be taken to ensure that any investments made within the OB do not disqualify the bond as an OB, albeit an IFA who is familiar with OBs will be able to advise on which assets can be invested into and OB issuers are generally quite stringent in which assets can be invested into.

Growth shares

Where there is already an investment company in the family, additional thought needs to be given to how the shares can be passed between generations.

It is not possible to gift shares in investment companies without CGT arising on the gift: for CGT purposes, the gift is treated as a deemed market value disposal. It is possible to gift the shares to a Discretionary Trust and hold over the capital gain arising on the shares, where the beneficiaries of the Discretionary Trust are over the age of 18. However, there are limits on the amount of value which can be gifted to the discretionary trust without a charge to IHT arising under the Chargeable Lifetime Transfer rules. There are also ongoing implications of assets being held in a Discretionary Trust, which are outlined within the Discretionary Trust section of the article.

Growth shares are shares which begin to obtain rights after the value of the company has exceeded a certain threshold. At this point, value ceases to accrue in the originally issued shares (known as the Frozen Shares) and instead accrues in the new Growth Shares. We usually see relatively complex rights in respect of voting and dividends attached to the Growth Shares, with the Growth Shares obtaining increased rights as the company increases in value in excess of the threshold.

A key point for Growth Shares planning is the valuation at which value stops accruing on the Frozen Shares and instead goes to the Growth Shares. If the value is too high, then the impact of the planning will be reduced as value will continue to accrue in the estate of the individual who holds the Frozen Shares. If the value is too low, then there will be real value in the Growth Shares on their issue, which will result in tax charges on their issue or transfer (depending on the method through which the planning is undertaken).

Valuation is an art and not an exact science: if you ask three different valuers for their valuation, you will inevitably get three different valuations. They key point, however, is that a professional valuer is used for the valuation. As tax professionals, this is not work that we should be undertaking!

It is also important to remember that the Growth Shares will be a new share class for the company, with their own bespoke rights. As such, we usually work with a lawyer to redraft the articles of the company to bring in the new share class. During this process, sit down with the family to work out if adding further provisions to the articles would help protect the company over the longer term. We usually seek to add provisions around who the shareholders can be and what happens if a shareholder were to become bankrupt.

Discretionary Trusts

Discretionary Trusts (DTs) are a useful mechanism to enable an individual to reduce the size of their estate, by making gifts to a DT, but retain control over the assets, by being a trustee of the DT. It is worth noting that the person making the gift (known as the settlor) should not also be someone who benefits from the trust (the beneficiary), otherwise the planning may become ineffective.

Every seven years, an individual can gift up to £325,000 worth of assets into a DT without there being any immediate IHT charges. If an individual was to gift more than this amount, then the excess is a Chargeable Lifetime Transfer (CLT) and subject to IHT at a rate of 20% if the IHT is paid by the DT, or 25% (to gross up the amount) if paid by the settlor.

When Growth Shares are used as a planning method for investment companies, the original shares which have a frozen value can be gifted to the DT every seven years. Given that it is possible to hold over the gain on the shares on their gift to the DT (where the settlor is not a beneficiary), the interaction of these two planning methods can be quite beneficial when IHT planning. Consideration should be given to the value of the shares gifted to the DT: should the value at the date of gift be £325,000 or should the total future value of the shares gifted be £325,000? This will depend on whether you are wanting to avoid the IHT charges outlined below.

The trustees of the DT are subject to a number of different tax charges:

• income tax on income received by the DT: this is payable on income over £500 per year at a rate of 39.35% on dividend income and 45% on other income;
• CGT on gains realised within the DT: this is payable on gains made of over £3,000 per year at a rate of 20% (noting that the rate increases to 24% for residential property);
• IHT ten-year charges: these rules are quite complex, but in principal the value of the DT in excess of £325,000 is subject to IHT at rates of up to 6%; and
• IHT exit charges: again, these rules are quite complex, but in principal when the DT appoints an asset to the beneficiaries of the DT a pro-rata version of the ten-year charge is levied at a rate of up to 6%.

Before you do anything…

As a final thought, before any planning is undertaken, there are three key things to consider:

1. How do the family dynamics work: can children be trusted and is the wealth protected against divorce?
2. Cost versus benefit: how much will it cost to implement and then service the solution annually compared to the amount of IHT which will be saved?
3. Joined up thinking: have the family’s IFA and lawyers been included in the discussions to make sure you have the full facts and everyone is happy with the proposed solutions as a basis from which to move forwards?

The article was originally published in Tax Journal Issue 1674 and is available to subscribers here on the Tax Journal website.

Our tax and trust specialists would be pleased to discuss your family situation and goals, and the best ways for you to create and preserve family wealth. Get in touch to find out how we can help you.