Jonathan Gain of Stellar Asset Management discusses how business property relief can be used to mitigate inheritance tax
Inheritance tax (IHT) is triggered when, in its simplest terms, an asset is transferred from one party to another typically on death. However, in reality there are exemptions and therefore complications as to how a liability to IHT can be mitigated.
Firstly, we all have an allowance where assets can be transferred with no liability. The current threshold is £325,000 per individual. We are also able to make gifts during our lifetime which in monetary terms are relatively small.
We can also enter into arrangements on trust for our beneficiaries. The liability to IHT in respect of gifts and certain types of trust falls away if we are still alive seven years after we made them.
For most people in the UK, IHT is not given great consideration principally because of the belief that it only affected the rich. This is no longer the case and many issues being faced by families today are a direct result of being dragged into the IHT net by stealth means.
Over the past ten years the number of estates liable to IHT has increased from 19,500 to almost 50,000. This has arisen for two reasons.
Firstly, because individual's principal asset, their family home, has increased at a greater rate than the threshold at which the taxation liability kicks in. In 2000, the average family home in the UK was valued at £81,000 and the inheritance tax threshold was £231,000. Today, those numbers are £167,000 and £325,000, an increase of 106% and 45% respectively.
Secondly, the inertia factor. Once a client is past retirement age their attitude to financial planning is at its lowest, particularly if they have not invested outside their pension in their lifetime.
Therefore there is likely to be a lacksadaisical approach along the lines of "the kids can afford it" or "I never had these benefits".While these may be plausible sentiments there are not many people who would prefer to pay more tax than absolutely necessary.
This is more so the case with IHT if you consider the fact that these assets have been accumulated from post-tax resources such as earnings or other disposals.
IHT is a tax liability which can be planned for and it is possible that every estate (including multimillion-pound estates) in the country could be made available to beneficiaries without any liability to IHT.
The more traditional routes of IHT mitigation are through gifts and trusts.
However, these do have significant drawbacks. Firstly, they result in a complete loss of control by the individual.
The title to the asset is passed to another person who can do with it what they like and may not be how the donor envisaged his or her legacy. If we then start to think about restriction on use and appropriate timeframes, then this requires time and money spent with a financial adviser. This process will also tend to involve more family members and can therefore take considerable time to agree.
Secondly, these options require the donor to live for seven years from the date the gift or trust was made. Finally, legislation around trusts changes regularly - and never in an investor's favour - most recently the requirements to disclose new schemes under the Disclosure of Tax Avoidance Schemes (DOTAS) regime.
With so many options available it is an area which is extremely complicated and requires the expertise of an independent financial adviser.
All is not lost, as there is a way of mitigating IHT without the need to relinquish control and enables estates to be free of IHT within two years.
Unfortunately, our research shows that this simple area of financial planning is not widely known.
This mitigation strategy is available through business property relief, or BPR.BPR enables you to claim relief on any business assets that you own and includes shares in qualifying businesses. The types of company which qualify for BPR must be unquoted although this definition includes AIM and Plus markets companies and they must also actively trade, that is, they cannot be an investment company.
There a number of established options of utilising businesses which qualify for BPR. The two most common are AIM portfolios and forestry.
However, there are other trading opportunities which can be considered and these include:
• property development
• owning and managing public houses
• debt factoring
• leasing and
• renewable energy
Most of these trades do offer a lower-risk profile as they are asset backed which, provided you do not borrow against these assets, do offer security over the long term.
There are two fascinating areas of planning which can also be incorporated under any BPR qualifying investment.
Business asset rollover relief
Business asset rollover relief enables someone to defer any capital gains tax due when business or trading assets are disposed.
If they acquire other assets costing the same as, or more than, the amount received on a disposal of the old assets, the relief allows the individual to postpone paying tax until disposal of those new assets. If new assets are acquired for less than the amount received on the disposal of the old assets, partial relief will be available.
You must acquire the new assets, or enter into an unconditional contract for the acquisition of the new assets, in the period twelve months before, and thirty six months after the disposal of the old assets.
Replacement relief utilises the characteristics and timescales of business asset rollover relief except that it enables the asset owner to continue to benefit from 100% relief from inheritance tax.
Therefore for a business owner who is looking to sell or has indeed already sold, further tax planning may be considered.
Mr Delamare has agreed to sell his printing business for £1 million having built the business from scratch five years ago and does not wish to pay CGT of approximately £280,000. He has previously used his entrepreneur's relief.
Mr Delamare is no longer keen to have all his assets in one asset class and therefore could take advantage of vehicles offering different qualifying trading activities.
Mr Delamare could reinvest the £1 million proceeds in his own private limited company and participate in a range of trades which qualify for business property relief. By doing so he remains in control of the money, has claimed CGT deferral through business asset rollover relief and will continue to protect the sales proceeds from IHT through replacement relief.
If this money is left in the company, then, upon death, the CGT liability will disappear and also no IHT will be payable on this part of his estate.
The trading company environment also enables Mr Delamare to take income arising from trading profits should this be desirable.
For the more adventurous client, enterprise investment schemes or EIS also provide probably one of the most effective opportunities to mitigate taxation.
EIS also enables investors to mitigate IHT through business property relief legislation but it also provides an income tax relief of 30% of the amount invested and can be used to defer any amount of capital gain.
As a consequence of the tax reliefs available the investment risk is the trade off. EIS legislation is designed to provide growth capital to small and growing businesses - those with assets of less than £15 million and accordingly there is the possibility of some failure.
Well-structured and managed EIS opportunities typically provide for a portfolio approach where investment is spread across a number of companies which mitigates this potential impact. Another mitigating factor is the ability to claim these losses against tax (either income or capital - the client can decide).
In its simplest form, if all EIS investments are worthless, the investor will have only lost 35p in the pound as income tax relief will have claimed for 65p.
This is calculated by adding the 30p initial relief to 50% income tax relief on the net loss of 70p making a further 35p. (Assumes highest income tax rate payer).
EIS tax planning example
We have a high net worth couple who are interested in estate planning. They have a house worth £500,000 and cash in the bank of £150,000. This total of £650,000 conveniently is equal to their nil rate bands and would be exempt from inheritance tax.
They also have significant invested assets which have an unrealised gain of £1,000,000. What are they to do?
If they sell their assets to put the proceeds into something tax
efficient, they will crystallise the gain and have to pay £280,000 in capital gains tax.
If they do nothing with the gain, there will ultimately be a charge of £400,000 on the estate for inheritance tax
However, if they put the £1,000,000 gain into an EIS opportunity they could defer the gain and after two years, the investment in the EIS will be outside of the estate.
This gain can be permanently deferred in it remains in an EIS investment as upon death of the investor the gain is no longer liable to capital gains tax.
This is a useful tool for anyone caught in the situation of having pregnant gains and a potential IHT liability.
Jonathan Gain is CEO of Stellar Asset Management
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