Keeping It In The Family

Alan Pink considers the tax problems that can arise when giving a share of the business to other family members, and outlines some possible solutions. 

 

This article looks at a specific family situation that can bristle with problems if not handled correctly: the situation where a shareholder in the family business wants to give away shares to other family members.  

 

We’re going to make two assumptions at the outset: firstly, that the business is successful and the company is therefore valuable; and secondly, that it is a trading business rather than an investment business – so the problems of capital gains tax (CGT) on a gift of shares can be easily avoided by putting in a ‘holdover election’, postponing any CGT on the shares until they are actually sold for cash by the donee at some future date. 

 

Gifts of shares in the family firm can have a number of motivations. It’s natural for family members to stick together (particularly in some communities), and for those who have ownership of the business to want to bring in others who haven’t, in order to provide them with an income. As with anyone, family or not family, the common view is that it motivates a person to get involved in the business and work hard if they’re given shares (in reality this is sometimes the case, and sometimes not).  

 

Sometimes the motivation is inheritance tax (IHT) planning, taking advantage of the ability to make gifts as ‘potentially exempt transfers’, which are exempt from the tax after the donor has survived the gift by seven years (if the business is a trading business, very often business property relief (BPR) would relieve the value of those shares from IHT completely in any event; however, this isn’t always the case, where there are assets in the balance sheet of the company which aren’t strictly trading ones. Also, one can never rely on the availability of a generous relief like 100% BPR being retained by a constantly tinkering government). 

 

The lion in the path 

The one massive tax issue with giving away shares in a trading limited company to someone else is in the ‘employment-related securities’ legislation. Our legislators today don’t know how to make anything simple, and this fills up page after page of the legislation (in ITEPA 2003). But the basic problem can be simply expressed: if shares are gifted to somebody by reason of their employment, and those shares have a value, that person will be charged to income tax on the value of the shares received.  

 

Where you’re talking about gifts to other family members, the first question to answer is whether the gift has actually got anything to do with that person’s employment with the company. There will be some situations where it’s clearly some other motive, such as natural love and affection, which has prompted the gift. A gift to one’s husband or wife is very unlikely to be a coldly calculated piece of staff motivation. But where the relationship is less close, you can easily end up getting into one of our tax system’s notorious grey areas.  

 

So, you can have the problem that you don’t actually know whether a possibly substantial income tax charge is going to arise as a result of your gift (in addition to income tax, there’s also a concomitant employer’s National Insurance contributions (NICs) charge on the employer company). We are talking about gifts here, and it’s true that the tax could be avoided if the recipient actually paid a fair whack for the shares. However, this brings us on to the other problem, or perhaps part two of the same problem: if there is a tax charge, how much is it?  

 

Because of the rule that says that the recipient is taxable on the value of the shares, the next issue is determining precisely what that value is. This is a notoriously difficult problem where you are talking about a small, closely-held company. There is no market in the shares and no hard and fast rules for determining how to value the shares. It’s not unusual, in practice, for negotiations on private company share values to go on for several years, between the accountants acting for the company on the one side and HMRC’s Shares And Assets Valuation Division on the other.  

 

Are HMRC approved share schemes like the enterprise management incentives (EMI) any help? These are meant to be ways, after all, of encouraging the use of share awards in motivating employees.  

 

Unfortunately, and as a general rule, I think the answer to this question has to be ‘no’. To take EMI as an example, what this enables an employee to do, basically, is receive shares at an undervalue without paying income tax – but the undervalue cannot be less, if this desirable tax result is to be achieved, than the value of the shares when the arrangements are first entered into. In fact, it’s a way of motivating individuals by not taxing them on gains in value of the shares during the period between the granting of share options and the employee actually acquiring those shares. 

 

It’s also worth pointing out, in the context of what this article is about, that there are restrictions on people who are too closely connected with current shareholders, preventing them receiving shares under the approved EMI arrangements. 

 

Perhaps the most obvious way of coping with the uncertainty about whether there is a tax charge, and if so how much it will be, is to ask HMRC. In any business planning, it’s important to reduce the level of uncertainty as to the outcome of actions as much as possible. But I can see two immediate drawbacks with the idea of seeking the information straight ‘from the horse’s mouth’.  

 

Firstly, as any practitioner who has tried it will tell you, it’s extremely difficult to get through to anybody at HMRC that will give you an authoritative answer. Secondly, if you are in doubt on the question of whether the gift will be taxable, you are very much highlighting that doubt to HMRC by seeking their opinion. If the opinion is that the gift is taxable, it’s then very difficult for you to backtrack and self-assess on the basis of the ‘natural love and affection’ argument. 

 

So, let’s think whether there are any other solutions. 

 

In some circumstances, although it seems a complete ‘cop-out’, the ‘do nothing’ option will be chosen. If the person who owns the shares is elderly, has made clear his intention to leave the shares to the intended recipient in his will, and is trusted to do so, the motivational effect may well be much the same. And a very old tax case (involving Mr Hornby, the Inventor of Meccano) has established the general view that a bequest in a person’s will is more likely to qualify as non-taxable. 

 

A different sort of arguably ‘cop-out’ solution would be to establish some kind of ‘virtual equity’. In its simplest form, the company could say to the individual: “you will henceforth be entitled to X% of the profits of the business. Rather than giving you X% of the shares, though, we will work out the profit each year and pay you a bonus of that amount.” This is likely to be highly motivational in the right circumstances; indeed, possibly more motivational than shares because the bonus is cash in hand.  

 

A more structural solution would be to set up a new company to take on part of the company’s business in a process of diversification. If the new company is set up to operate a new business, which doesn’t have value at the outset, the issue of the founder shares to the individual concerned can have the motivational effect desired whilst actually bestowing on the person an asset which can be given a negligible value for the purposes of tax.  

 

More radically still, consider whether the whole business format can be changed from that of a limited company to a limited liability partnership (LLP). Unlike the position with shares in a company, it is generally regarded as possible to bestow a share in a partnership (which is how an LLP is taxed) on an individual without the value of that partnership interest being charged to tax on him.  

 

Needless to say, there are many tax and other implications of recasting the business as an LLP, but these should be considered in the right circumstances because very often they are very favourable implications.