What happens to your interest in a business in the event of your death will vary, depending on how that interest is structured.
1. Structure of Business Interest
a. Sole Trader
For a sole trader, the business assets will form part of the deceased’s estate and pass according to the terms of the will or intestacy. The estate will be subject to a charge to inheritance tax, if the total value of the estate exceeds the nil rate band available in the year of death. In the tax year commencing 6 April 2010, the nil rate band for each individual was £325,000. Various exemptions and allowances apply.
b. Unlimited Partnership, Limited Liability Partnership (LLP) & Private Limited Company
If you’re entering into a business arrangement with another individual, it’s strongly recommended that your rights and obligations in connection to the business be set out in a formal agreement.
The treatment of business assets held in an unlimited partnership or in a limited company are similar for inheritance tax purposes. In an unlimited partnership if there is no partnership agreement (or indeed if there is one but it contains no specific provisions relating to duration) the partnership will cease on the death of one of the partners. The deceased’s share in the net assets of the partnership or share in the newly formed partnership as carried on by the continuing partners passes into the deceased’s estate. In this case, then it is usual for the remaining partners to buy the deceased’s share in the partnership from the estate or for the beneficiaries under the estate of the deceased to carry on the business with the surviving partners.
The nature of an LLP is that its terms are more likely to be let out formally. On death of all of the partners, agreement normally sets out how the balances of the deceased members current and capital accounts are retrieved. These pass into the deceased’s estate. Business property relief may be available.
A shareholding will pass into the deceased’s estate, and the same options will be available to the beneficiaries of the estate of the deceased. Either the shares will be sold to the remaining shareholders, or the beneficiaries will take over as shareholders.
How partners or shareholders wish to handle these issues must be properly considered when entering any formal agreement in relation to the business.
2. Assessment
From a personal tax and planning perspective, several issues need to be considered:
- Whether it is appropriate for your beneficiaries to carry on your business.
- How your interest will be valued at your death.
- How the remaining shareholders or partners will raise the funds to purchase your interest from your estate.
- Whether the interest will attract business property relief from inheritance tax.
3. Life Insurance & Business Valuation
We can assume that the beneficiaries don’t wish to carry on the business of the deceased and instead, the remaining shareholders or partners agree to buy out the deceased’s share.
In order to raise funds for this it’s usual for shareholders or partners to purchase life insurance, of a value equal to the value of the shareholding. On the death of a shareholder or partner, a life insurance policy for the benefit of the remaining shareholders or partners will be realised, and the shareholders or partners can purchase the shares with those monies.
The value attributed to the business needs to be very carefully considered at the point that life cover is purchased to ensure there is sufficient cover to purchase the shares at their market value at the time of death.
HMRC (Her Majesty’s Revenue and Customs) will not necessarily agree any valuation given at the point when the asset is declared for inheritance tax purposes. They may raise an inquiry and deem the market value of the business interest to be higher than that of the life cover. If insufficient cover has been taken, the beneficiaries might find they are taxed at the market value as agreed by HMRC, but only receive monies equal to the lower level taken out as life cover.
In monetary figures, if the life cover was £100,000, but HMRC deemed the value of the interest to be £200,000 and no business property relief is available, then tax will potentially be payable at 40% of £200,000, creating a tax bill of £80,000. Of the £100,000 that the beneficiaries receive, £80,000 will be paid in tax.
4. Finance Options
An additional problem can arise in the timing of the transfer. The beneficiaries of the estate will usually not be able to sell the shares to the surviving shareholders until they have a grant of probate. In order to obtain a grant inheritance tax must be paid.
Where an estate is illiquid, this can cause significant problems. Unless business property relief is available, the beneficiaries might need to obtain expensive bridging finance to pay the tax in advance of selling the shareholding or partnership interest to the surviving shareholders or partners. The company might wish to consider pursuing finance options with banks that might be prepared to offer a standing loan facility.
5. Business
It might be that the business interest will attract business property relief from inheritance tax. Where business property relief is available, there is a further tax planning opportunity for married couples.
If the asset which attracts business property relief passes from the husband to the wife (or vice versa) under the terms of the will, it will be exempt from inheritance tax using the spouse exemption. It is very likely that during the course of the transfer, or soon after, the asset will cease to be a business asset and become cash. At this stage the cash in the surviving spouses’ estate will attract inheritance tax on their death. Her estate will have available to it the nil rate band and any of her husband’s unused nil rate band, as well as the usual relief and exemptions. Everything else is likely to be taxed at 40%. The benefit of the business property relief will have been lost by passing the asset using the spouse exemption.
In order to harness the business property relief on the death of the husband, it is possible to prepare a will to create a wills trust containing the business asset. This will create a separate gift of the asset which will be exempt from inheritance tax on the basis that it attracts business property relief. Please be aware that a specialist’s advice is needed in this area, as business property relief can be lost unless the asset is handled correctly.
6. Summary
Personal and private planning are often overlooked when structuring business interests, but it is vital that any shareholder or partnership agreements are reviewed by someone who is a specialist in private wealth planning. Not doing so might result in your beneficiaries losing a significant amount of the interest to inheritance tax.
The advice contained above is particular to UK domiciles and residents. Non domiciles and residents may have other planning available to them, and we can advise in that area separately.