Inheritance Tax: The Forgotten Tax on a Company Sale – Vanessa Clark, director at Azets
By Vanessa Clark, director at Azets
You are selling a company and you intend to live for many more years to enjoy the proceeds. It is true that if you have a long retirement and you spend the proceeds any concerns about Inheritance Tax fall away, but what if that doesn't happen, and why does Inheritance Tax become an issue?
While a person owns shares in a trading company, typically those shares can qualify for 100% business property relief (BPR) and so on death the shares can pass free of Inheritance Tax. We would of course review any individual company to make sure that the shares do qualify for relief, but for now let us assume that the shares are eligible for relief.
The shares are then sold, which creates a capital gain, and triggers a Capital Gains Tax bill at either 10% or 20%. In addition, as you now have cash and not shares, entitlement to BPR has ended and the proceeds net of Capital Gains Tax are subject to Inheritance Tax if you die without having done any planning.
So, let us illustrate this with an example. Barbara owns 100% of a trading company and sells the shares for £10 million. There is no base cost and so the capital gain is £10 million.
Capital Gains Tax £ 1,900,000
Net Proceeds £ 8,100,000
The next step is to look at the tax outcome if Barbara dies shortly after the shares are sold.
Net Proceeds £8,100,000
Inheritance Tax @ 40% £3,240,000
Net Legacy £4,860,000
With a mix of Capital Gains Tax and Inheritance Tax more than half of Barbara's life work in building up her company has been taken by HMRC.
We often have pre-sale discussions about Inheritance Tax planning. This can lead to the preparation of a personal cash flow forecast to show how much a client will gain from a forthcoming sale, and we then make assumptions as to how the proceeds are to be invested and the likely levels of expenditure in the remainder of the individual's life. The benefit of this work is that it is the precursor to discussions about what portion of the proceeds will be needed by the client and what portion will never be spent in that person's lifetime. It is that excess figure that interests us as the client is in essence holding that money for future generations, and if no planning is put in place those beneficiaries will only receive 60% of the value, net of Inheritance Tax.
If there is planning, but it is done after the sale, and you are giving away cash, this places limits on you. If you want to give money into trust, and you do not want to incur a form of Inheritance Tax, called an Entry Charge, there is a cap on gifts to trust of £325,000 every 7 years.
However, let us assume that Barbara has a meeting with us pre-sale, and it becomes obvious to her that while she might spend half of the net proceeds if she chooses an extravagant lifestyle, the other £4 million will never be spent and so her son and daughter will have suffered 40% Inheritance Tax on that money if she holds on to it, a cost of £1.6 million. We suggest to Barbara that immediately before the sale, she gifts half of her shares in the trading company to a discretionary trust of which she is a trustee and her children and future generations are the beneficiaries.
Barbara and the trust sell the shares and each of them is responsible for the warranties and indemnities under the Sale and Purchase Agreement. Although the market value of the shares gifted to the trust is £5 million, there is no Entry Charge, as the value of the shares, net of BPR is £0, and so below the threshold of £325,000. If Barbara were to die within seven years of the sale, there could be a charge to Inheritance Tax on the value of the shares, as at the time of her death, the shares have been turned into cash, but this potential liability has a decreasing term of risk and so typically the trust takes out a decreasing cover term assurance policy on Barbara's life for that risk.
With proceeds of £4 million in the trust, net of Capital Gains Tax, the trust is likely to have to pay 10 year charges. For Barbara's trust, the potential 10 year charge is £220,500, if the value is still £4 million in 10 years, but that is cheaper than the potential liability of £1.6 million of Inheritance Tax if that element of the proceeds remain in her Estate.
In addition, the growth in that value as the funds are invested will be outside Barbara's estate.
All of these opportunities are opened up for Barbara by doing the Inheritance Tax planning for the company sale at the right time, which is before the sale has happened.
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If you have any questions on Inheritance Tax planning, please get in touch with a member of our specialist team or your usual Azets advisor.
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