How to save inheritance tax with business relief

How to save inheritance tax with business relief

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    As you approach retirement, your thoughts naturally turn to protecting your assets to pass on as much as possible to your loved ones when you are gone. Inheritance Tax can eat into the legacy you leave behind, which is a source of frustration and concern for many. But if you are a business owner, there is a way to reduce or even eliminate Inheritance Tax liability through business relief.

    If an asset qualifies for Business Property Relief, then its market value may be exempt from Inheritance Tax either in its entirety or to a certain percentage. This can represent an Inheritance Tax saving of as much as 40%. The big advantage is that you usually only need to hold the investment for two years to qualify.

    Business relief is a powerful tool to shield your hard-earned wealth and relieve the tax burden for those you leave behind. In this article we are going to briefly touch on how Inheritance Tax (IHT) is calculated, look at strategies for using Business Property Relief (BPR) to help mitigate or reduce your inheritance tax liability, as well as the pros and cons.

    To discover more about how you can safeguard your family’s financial future, please get in touch with the experts at Heritage Financial Planning.

    What assets qualify for Business Relief?  

    Business assets, shares in unquoted companies, and investments in certain companies listed on the UK Alternative Investment Market (AIM) are eligible for Business Property Relief. Additionally, certain types of plant and machinery may also qualify.

    Business property and the rate of relief available are as follows:

    PropertyRelief Available
    Business or an interest in a business100%
    Unquoted shares or those on the Alternative Investment Market (AIM) 100%
    Unquoted securities which, on their own or combined with other unquoted shares or insecurities, give control of an unquoted company100%
    Quoted shares, which give control of the company50%
    Land or buildings, machinery or plant used wholly or mainly for the purposes of the business carried on by a company or partnership50%
    Land or buildings, machinery or plant available under a life interest and used in a business carried on by the beneficiary 50%

    How is inheritance tax calculated?

    Your estate is usually exempt from Inheritance Tax if its value is below the £325,000 threshold, known as the ‘nil rate band’.

    Your spouse or civil partner can inherit your unused nil rate band, and they can be combined to create a double amount of nil rate band of £650,000 (£325,000 x 2). 

    Furthermore, if you leave your home to your children or grandchildren, then both you and your spouse or civil partner can benefit from something called the Residential Nil Rate Band, which is a further £175,000 exemption for each of you.

    Importantly, for you and your spouse or civil partner to receive the full residential nil rate band, the value of your property must be above £350,000 (i.e. £175,000 x 2). 

    This means that for a married couple or civil partnership, up to £1million is usually shielded from inheritance tax (assuming your home is valued at or above £350,000). 

    ExemptionValue
    Spouse 1 Nil Rate Band£325,000
    Spouse 2 Nil Rate Band£325,000
    Spouse 1 Residential Nil Rate Band £175,000
    Spouse 2 Residential Nil Rate Band£175,000
    Total£1,000,000

    It is worth noting that if the value of your estate is above £ 2 million, the Residential Nil Rate band will be reduced by £1 for every £2 over this threshold.

    Example of how business relief can reduce inheritance tax

    John was married to Lucy, who passed away last year. She hasn’t used her Nil Rate Band or Residential Nil Rate band, so £1million can be shielded from Inheritance Tax. The current value of John’s estate is as follows:

    AssetValue
    Main Home£600,000
    Buy-to-let£300,000
    Cash£100,000
    ISA£200,000
    Total Estate£1,200,000

    As the estate is £200,000 over this £1m threshold, the current Inheritance Tax bill would be £80,000 (£1.2million x 40%).  

    If John was to invest £200,000 in qualifying shares that trade on the London Stock Exchange Alternative Investment Market, assuming he holds the investments for at least two years and business property relief applies, this would eliminate his Inheritance Tax liability, assuming his other assets didn’t increase in value.     

    This is why Business Property Relief can be so effective; the timeframe in which the investment can fall out of your estate is relatively short at two years, compared to other strategies such as gifting, which can take up to seven years for the gift to fall out of your estate completely.   

    Will my business qualify for business relief?

    The purpose of business relief is to incentivise investment in businesses that contribute to the economy, such as trading businesses or certain types of shares in unquoted companies. HMRC defines a qualifying business as “a business carried on in the exercise of a profession or vocation”. This applies to sole traders, partnerships and limited companies.

    If you own such a business or have an interest in a business, providing you have held it for two years, you can claim 100% relief, and the business asset will be exempt from Inheritance Tax.

    However, the relief doesn’t extend to some businesses, in particular, investment businesses. Businesses are exempt from business relief if they are ‘wholly and mainly’ involved in the following activities:

    • Dealing in securities, including stocks and shares
    • Dealing in property, land and buildings
    • Businesses involved in making or holding investments

    This rules out the likes of businesses that invest in property and investors who have incorporated their buy-to-let properties.

    How to define ‘wholly and mainly’ activities

    Generally, if more than 50% of a business’s activities are involved in the dealing of securities, land and buildings, then it will be deemed to be ‘wholly and mainly’ involved in such activities and will not qualify for business property relief.

    However, if less than 50% of a business is deemed ‘wholly and mainly’ involved in the exempt activities, certain investment properties could still qualify for BPR, while they wouldn’t have if owned by an individual. This highlights how holding investment properties in a business structure can impact eligibility for tax relief.

    What happens if I die within two years?

    As we have said, to qualify for business property relief, you must have held the business assets for at least two years. So what happens if you die in that timeframe?

    Generally, the investment will not qualify for the relief, and it will be added to your estate. However, there is one exception.

    If you inherit an asset from your spouse who owned it for less than two years, your period of ownership will be combined with your spouse’s. If the combined ownership totals more than two years, the property becomes eligible for business relief.

    Business Property Relief on investments in unquoted companies and AIM-listed shares 

    If you own shares in an unquoted company or even those listed on the Alternative Investment Market, provided the company passes the trading test and is a qualifying business, then the investment may qualify for business relief. That means certain investments are extremely tax-efficient.

    Advantages of Business Property Relief

    1) Relatively quick  – If an investment or business interest qualifies for Business Property Relief, then the qualifying business will fall out of your estate and will not be subject to Inheritance Tax.

    In comparison, a Potentially Exempt Transfer or lifetime gift takes a full seven years for the gift to fall outside of your estate. 

    Let’s look at an example. John invests £200,000 into a portfolio of AIM shares that qualify for Business Property Relief. He dies after two and a half years of making the gift, so the £200,000 is outside of his estate. 

    How about if John had gifted the same amount to his son?

    As he died within three years of making the gift, the full amount will still be part of his estate and taxed at 40%, which is a total of £80,000. 

    2) Retain ownership – Another advantage of BPR compared to other inheritance tax mitigation strategies, such as gifting, is that you retain ownership of the asset. This can have implications if you live longer than expected or if you need the assets to fund your retirement or future care fees. 

    If you do gift assets to your loved ones, this can also present a challenge in what they do with the money, particularly if they are younger. There is a real risk they could go and ‘blow through it’ or mismanage it in general. 

    Disadvantages of Business Property Relief – ‘tax tail wags the dog’

    One disadvantage of Business Property Relief concerning an unlisted company is its potential illiquidity. It’s unlikely to witness a return unless the business is acquired, listed on the stock market, or pays dividends. Since these companies are often younger or start-ups, dividend payments are unlikely, which could pose a challenge for retirees needing investment income during retirement.

    Additionally, the risk of capital loss is higher due to the immaturity of these businesses.

    Although AIM shares are traded on a stock market and fairly liquid on the whole, you would be investing solely in UK-listed companies.

    UK AIM stocks have performed rather poorly over the past 20 years when compared to an index made up of smaller global companies, such as the MSCI Global Small Cap Index.

    This is reflected in the graph below, which shows the UK FTSE AIM Market index (A) compared to a benchmark of global small-cap companies (B):

     UK FTSE AIM Market index (A) compared to a benchmark of global small-cap companies (B)

    Business property relief investments and AIM investments are usually undertaken to reduce IHT over a relatively short timeframe and not as a pure investment strategy. But it does highlight that the ‘tax tail could be wagging the dog’ and the inheritance, at least in this example, would be less than had you invested in the global small-cap stock market index.  

    However, it is impossible to predict future investment returns, and past performance is not a guide to future returns. It is not altogether impossible to imagine a scenario in which this chart is reversed, and UK equities outperform their global peers in the future. 

    Business Relief investments and investment managers can be expensive

    If you do look to offset Inheritance Tax against qualifying business relief investments, be aware that investment manager fees can be expensive compared to index funds and Exchange Traded Funds (ETFs).

    It is not uncommon for initial fees upwards of 2-3% and ongoing fees around a similar mark. Along with the historical underperformance of the AIM market, this can be viewed as another scenario of the tax tail wagging the dog. 

    Get advice on inheritance strategies from Heritage Financial Planning

    The experts at Heritage are dedicated to helping our clients protect their estates against unnecessary taxes, including Inheritance Tax, Income Tax and Capital Gains Tax. As highly experienced financial advisers, we can help you put strategies in place to maximise your investments and minimise the tax burden for your loved ones.

    Please contact us to book an initial consultation.

    HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen. The Financial Conduct Authority does not regulate tax planning. Tax planning/will writing is not regulated by the Financial Conduct Authority. Past performance is not a reliable indicator of future performance and should not be relied upon. The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested.

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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