Pass it on! Gifting family company shares

 

There’s a general feeling that it’s a good idea, not just for the sake of the health of the family business, but also from a tax planning point of view, for the older generation to pass the shares in the family company down to the younger generation. 

 

In fact, from the tax planning point of view, it isn’t always unambiguously a good idea, as I’ll come on to illustrate. But the tax system certainly helps where the company concerned is a ‘trading company’ as defined.

 

To explain clearly what follows, I need to distinguish between the two different rules that apply for capital gains tax (CGT) on the one hand and inheritance tax (IHT) on the other. 

 

For CGT purposes, the definition of a ‘trading company’ is that it has no non-trading activities which are ‘substantial’. This infuriatingly vague definition has been glossed by HMRC to mean that the non-trading (i.e. investment type) activities should not be more than 20% of the whole. They are distinctly unhelpful in explaining what the 20% measure applies to; whether it is gross or net income, gross or net assets, or management time; but at least this is a start. 

 

The importance of trading status for CGT purposes in the context of what this article is about is that a gift of shares in a trading company can be the subject of a CGT ‘hold over relief’ claim. Where the gain is held over, no tax generally becomes due on the deemed sale of the shares, which is how CGT treats a gift.

 

For IHT purposes on the other hand, a company will often qualify for 100% business property relief (BPR) from the tax (i.e. it is effectively left out of account completely in calculating the IHT) if the company is at least 50% trading. In principle, a company (if you could find it) which was exactly 50% trading and exactly 50% investment in the nature of its activities would qualify for full relief. 

 

So, let’s look at the tax planning considerations as they apply to companies with various levels of investment activity. 

 

Companies which pass the ‘trading company’ test for CGT purposes

If you are reasonably sure, either because the company has no non-trading activities or because its non-trading activities are clearly within the 20% limit on all possible criteria, there’s normally no problem with giving away the shares to the next generation(s) without incurring CGT. The deemed gain can be held over, as explained, although hold over relief is restricted in respect of any chargeable non-business assets (TCGA 1992, Sch 7, para 7). 

 

On the other hand, by definition almost, a company which qualifies for hold over relief as being a trading company for CGT purposes will always qualify for 100% BPR from IHT. So, if tax planning is all you’re thinking about there would seem, on the face of it, to be no reason to bother making the gift during the lifetime of the older generation. It can be left to the next generation in their will with no IHT in any event. 

 

However, there are two considerations which might modify this straightforward logic. Firstly, the planning assumption is that 100% BPR will always apply, and in particular will apply on the date of the current shareholder’s death. The way politicians chop and change our tax system, particularly the long-term capital taxes, might lead you to doubt the wisdom of relying on this. 

 

Secondly, and more concretely though, there is in some companies a tendency for the trading element to become less as a proportion of the whole, and for the investment element to increase. For example, if the company is profitable and retains its profits, it may gradually spend its surplus cash on acquiring investment assets, like rental properties. If this is a likely future tendency in the company, it could be a good idea to make the gift of the shares to the younger generation now whilst it clearly qualifies for hold over relief. 

 

Let’s have a look at two examples; one of a company which is on the borderline between trading status and non-trading status for CGT purposes, and one of a company which clearly does not qualify for trading status for CGT purposes, but is still at least 50% trading so as to qualify for BPR at 100% for IHT purposes. 

 

Mainly Trading Limited has as its principal activity providing management services, but has reinvested some of its (substantial) profits in a small buy-to-let rental property portfolio in Sussex. 

 

Due to increases in the value of the properties, these are now worth more than 20% of the company as a whole, although the income and time input lag behind the trading activities to a significant extent. The trade still takes 95% of the management time, and the income is still over 80% derived from the trade and less than 20% from the rents on the property portfolio. 

 

Because of the value issue though, father, who owns all the shares in Mainly Trading Limited, is hesitant to make his planned gift of shares in the company to his son, in case CGT ‘hold over relief’ turns out (after the event) not to be available. 

 

To get around this problem, a new company is set up with the son as shareholder, and the property which was acquired most recently (and which has the lowest inherent gain) is transferred to this company. Mainly Trading Limited has a small corporation tax charge on the chargeable gain, and there is also stamp duty land tax to pay. However, the effect is of ‘cleansing’ the balance sheet of Mainly Trading Limited such that it now clearly qualifies as a trading company on all criteria. Having done this, the gift of the shares takes place and a hold over election is made.

 

There is, in fact, an unresolved issue with the question of precisely when a company needs to qualify as a trading one, for hold over relief to be available. On one very arguable interpretation, however, it only needs to be a trading company at the time of the gift. 

 

If this issue had been foreseen, perhaps a parallel investment company could have been set up earlier, and money lent across, interest-free for that company to acquire the buy-to-let properties. An inert intercompany balance of this sort should not, in my view, count as a non-trading ‘activity’.

 

Libra Limited has roughly equal trading and investment activities, with the trading marginally predominating. Instead of the shareholder giving the shares to his son, he transfers them into trust for his son. 

 

As with transfers into trust generally, this is eligible for hold over relief from CGT whether it is a trading company or not. The problem with transferring into trust, which is the 20% IHT lifetime charge on the taxable value over the nil band, should not be a problem in this way because the company still qualifies under the IHT rules for 100% BPR. 

 

Finally, consider the following example, in which the whole wisdom of transferring a trading company down the generations is questioned, and an interesting alternative strategy is used.

 

Peter is approaching retirement, and has two substantial assets which are also sources of income; an investment property portfolio worth £1 million, from which he derives an annual income of £40,000; and 100% of the shares in a trading company, also worth £1 million, which pays him £40,000 dividends each year, even though his son is now the one who runs the whole business. 

 

Conventional wisdom would be to transfer the shares in the trading company to the son who, after all, is the one who is working in it. However, Peter only needs the income from one of his two major income producing assets to fund his retirement because he has pensions as well. So, he actually gives the property portfolio to his son, paying the (in this case, fortunately, modest) CGT. 

 

If Peter then survives for seven years after this gift, he will have no IHT to pay on it; or on the company whose shares he has retained, as it is still a trading company. If he had given away the shares in the company and retained the property portfolio, the IHT would have been £400,000.