by Maybeth Shaw, BDO Northern Ireland
It doesn’t always end well when families play Monopoly together, so too diversifying a family owned trading company by investing in property can have unforeseen tax consequences – potentially leaving families with large unexpected liabilities.
Property investment is commonplace within family businesses, often seen as a safe haven for cash or as a means of providing the founding shareholders with a retirement ‘nest egg’.
For nearly 30 years, BDO Northern Ireland have been helping family businesses across the province identify these issues and find the right solutions.
Consider the ‘typical’ family trading company. The parents are equal shareholders in the company (valued at £2m), with the next generation working in the business. The company decides to buy a commercial property (for £500k).
The commercial property is a pure investment, never used by the family business and let out to a third party.
As an investment vehicle for the holding of property, a corporate entity can prove tax efficient as all income and capital gains made from the investment will be taxed at the uniform rate of corporation tax (currently, 19 per cent).
This can be attractive for families, when compared to the tax position had they invested personally, given the income tax costs of withdrawing cash from the company and the personal income tax rate of up to 45 per cent on rental profits.
In addition, if the property investment is relatively small, it may initially be ‘sheltered’ from inheritance tax. If owned personally, the property investment would definitely be exposed to inheritance tax from the outset.
However, having non-trade assets on the company balance sheet can also restrict tax relief where a gift of trading company shares is made (e.g. from parent to child).
Problems for families can arise down the road, when it comes time to sell the business or in the unfortunate event of parents passing away, as the shareholders may no longer qualify for relief from capital taxes specifically designed to preserve wealth for family businesses.
The principal reliefs are;
• Entrepreneurs’ Relief from capital gains tax which can restrict the tax rate to 10 per cent on the sale of shares in a trading company (to a lifetime limit of £10m), and;
• Business Property Relief, which can exempt the transfer of trading company shares to the next generation from inheritance tax (a 40 per cent tax saving on the capital value of businesses).
The traditional problem for families can be that the capital values of the ‘core’ business and the investment will ebb and flow at disparate rates. Potentially, the growth in property value can outpace the growth of the business – especially, if the family trading business is well established.
Taking the above trading example 10 years on, let’s assume that the trading business has recently reduced in scale, having gross assets of £2m. However, the property investment has ballooned in value relative to the value of the trade (or further investments have been made) and is now worth £6m.
For all intents and purposes, the family may consider that little has changed in the interim period, directing their time to running the business, which in principle remains a trading enterprise.
However, for the purposes of UK tax legislation, this company may no longer meet the definition of a ‘trading company’ because the investment value, relative to the overall value of the company exceeds prescribed limits (broadly being 20% for capital gains tax and 50% for inheritance tax). In the example above, the investment value equates to 75% of the company’s gross assets (£8m).
Hence, the family may lose out on the available capital reliefs – which they would otherwise assume would be available to them. For inheritance tax in particular, this can result in a significant tax leakage for families, that may require the sale of further assets.
Further pitfalls arise if the family attempt to mitigate the problem without taking appropriate advice, and gift the shares to their children. If the company no longer qualifies as a trading company, the shares will not meet the definition of ‘business assets’ for Gift Relief purposes (or the relief will be restricted). Hence, crystallising a ‘dry tax charge’ i.e. a taxable capital gain will arise without cash proceeds to meet the liability.
Possible Solution: Protect the Trading Company
With some forward planning, the company could separate the commercial trading risk of the ‘core’ business from that of property investment – creating two separate companies i.e. TradeCo and PropCo. TradeCo will continue running the family business, having hived off the investment business.
Typically, it would be beneficial to take these steps before the value of the property investment becomes significant to that of the trade. Further, the family could consider transferring wealth to children as part of the tax planning exercise.
Subject to HMRC clearance, a corporate reconstruction would not crystallise a tax charge for either the company or the shareholders and would potentially preserve the shareholders’ entitlement to reliefs from capital gains tax and inheritance tax on the value of the trade. Further, it would allow the parents freedom to bring their children into the business, gifting shares in TradeCo (potentially free from a tax charge).
The PropCo shares would not qualify for Entrepreneurs’ Relief or Business Property Relief, but the family will have compartmentalised any potential tax leakage.
Tax reliefs exist to allow shares in family trading companies to be passed to the next generation.
Making investments (including in property), can restrict the reliefs available to families, unless suitable measures are taken at the appropriate time.
As trusted advisers to big and small family businesses alike, BDO Northern Ireland recommend that all family business take advice on these matters as early as possible.