While it is not usually possible to trace through gifts of cash for the purposes of the IHT gifts with reservation of benefit rules, that is partly why the income tax charge on pre-owned assets (POAT) provisions was introduced. Terry Jordan writes for Taxation magazine.
Inheritance tax implications of profits retained in a personal service company
My client retired from his employment several years ago. However, his former employer wanted to recruit someone with similar expertise, but was unable to find a suitable replacement.
Consequently, the firm asked my client to return to work for it, but he has been doing this as a contractor and has traded through his own company. From the nature of his work, I am reasonably happy that the IR35 rules do not apply.
The problem, if it is one, is that the client has not drawn all of the earnings from the company, and reserves in the region of £200,000 have built up. Given that the client and his wife have other assets that would use up the nil-rate band, the concern is whether there would be an inheritance tax liability on these monies if he dies.
The client is some years older than his wife and in the normal course of events he would be expected to die first.
Do we have anything to worry about? If we do, is there any planning that we could undertake to minimise any inheritance tax liability on these reserves?
Query 18,444 – Contractor
Reply from Terry “Lacuna” Jordan, BKL
Contractor’s client is concerned about the exposure to inheritance tax of the reserves in the client’s company in the region of £200,000. The first point to make is that, in strictness, it is not the value of the company’s assets that are exposed to inheritance tax. The exposure lies in the value of the shares in the company which, of course, will reflect the value of the underlying assets.
The shares are in an unquoted company and it seems that the client has owned them for at least two years. Inheritance tax business property relief at 100% is available to such shares under IHTA 1984, s 105(1)(bb) if the business carried on by the company does not consist wholly or mainly of making or holding investments (s 105(3)).
Where the business of the company is predominantly “trading” in nature there is the potential for relief to be restricted by reference to the value of “excepted assets” under IHTA 1984, s 112. From Contractor’s description, I should expect HMRC to seek to deny business property relief entirely to the value of the client’s shareholding.
We are told that the client might be expected to die before his wife and it might be that he would leave the shares to her either outright or on what are now termed “immediate post-death interest” (IPDI) trusts so as to benefit from the spouse exemption and the capital gains tax-free uplift in value on death.
His widow (or the trustees of his will trust) could then transfer the shares to younger generations free of inheritance tax as long as she survived seven years.
Another possibility would be for the client to transfer the shares to a discretionary trust for the benefit of adult children. That would constitute an immediately chargeable transfer, but on the figures no inheritance tax would be payable and the client would regain his nil-rate band in full after seven years. Potentially, capital gains tax holdover relief would be available.
Alternatively, sizeable dividends could be declared and paid to the client which would then be invested in enterprise investment scheme (EIS) shares. That would afford a measure of income tax relief and the EIS shares would benefit from 100% business property relief once owned for two years.–
