Tax-efficient distributions via family investment companies

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  • There are several ways to make tax-efficient distributions
  • Be careful when setting up the business

Shareholders of the family investment firm will have breathed a sigh of relief last summer when HM Revenue & Customs (HMRC) closed the unit it had set up two years earlier to investigate the use of vehicles by wealthy families for tax purposes.

As we noted in ‘When Should You Start a Family Investment Company?’, IC October 2020, Family Investment Companies are most often used by people with relatively large sums of money as a form succession planning. They have become increasingly popular since regulations introduced in 2006 made trusts less attractive.

While the unit’s creation sparked speculation that family investment companies would be the latest target of a wider government crackdown on ultra-high net worth individuals, HMRC minutes released in August found “no evidence” of a correlation between those who set up a family investment company and tax evasion.

‘HMRC research has concluded that people use family investment companies as a ‘planning strategy, often with the primary aim of generational wealth transfer and Inheritance Tax (IHT) mitigation’.

Sharon Wood, a tax specialist and partner at accounting firm Gilliland & Co, says she’s seen an increase in the popularity of vehicles since the start of the pandemic, with people deciding to sell their business and transfer the profits to an investment company. family investment.

Because family businesses are complicated vehicles for anyone unfamiliar with business structures, they are popular with those who have owned businesses and are familiar with the process of running a business.

In October 2020, we explained who family investment companies are suitable for, how they are taxed and how to start one. On top of that, there are also nuances to watch out for when it comes to making tax-efficient distributions. If you are considering setting up such a business, it is worth seeking professional advice to ensure that you have organized the structure in the best possible way to meet your needs.

Dividend payments

The mode of distribution of family companies depends on the constitution of the vehicle. Generally, however, distributions are paid to shareholders through the payment of dividends. Many family investment companies have multiple classes of shares, allowing for situations where parents control what the business invests in and when dividends are paid, while children have non-rights-based classes of shares. votes that receive dividends.

Shareholders pay tax on the dividends they receive at their marginal income tax rate. From April 2022, dividend tax rates increase by 1.25 percentage points, setting the tax at 8.75% for base rate taxpayers, 33.75% for rate taxpayers. higher and 39.35% for those paying additional rates. Shareholders who have no other income benefit from the personal income tax relief of up to £12,570 per annum. If they are already earning more than this amount, there is the £2,000 dividend tax allowance.

For parents who have set up a family investment company and pay dividends to their children, it is important to note that these dividends will be taxed at the parents’ income tax rate until the children reach the age of 18. age of 18. Julia Rosenbloom, tax partner at Tilney Smith & Williamson, says this is an especially important point for family investment companies that were set up to help pay for private school tuition.

Dividends paid by the company must come from distributable reserves. This includes any dividend income received from assets within the business – or rental income if the business has a property portfolio. It also includes any gain realized on the sale of assets within the business.

But Wood says she tends to find that family investment companies are used as vehicles to accumulate capital and help with IHT planning, rather than paying big dividends. This is despite the fact that family businesses generally pay corporation tax on annual profits, rather than dividend tax or capital gains tax on investments held. This can make it more tax efficient to hold high-yielding assets rather than high-growth assets within the company. Corporation tax is currently 19% and is expected to increase to 25% in April 2023.

Those who wish to pay dividends of different amounts to different children can do so by creating “Alphabet Shares”. This provides a different share class for each child, and each year the directors can decide what kind of dividend they pay to each share class. “Some parents like the idea of ​​flexibility, some wouldn’t dream of it,” says Wood.

Loan terms

Another key way to extract money from a family investment company is to set it up using a loan agreement. This means lending money to the business and then withdrawing from the loan instrument over time tax-free. However, children or grandchildren who are shareholders of the company could not draw from the loan. Another potential downside to using a loan account is that it will come under your estate for IHT purposes. Still, Wood says most of the family investment firms she meets include a loan agreement because it tends to be tax-efficient for the person setting up the business.

Wood has a client who put £10m into a family investment firm and withdrew around £150,000 a year. His plan is to give a portion of the loan account balance to his children, so part of the loan will flow out of his estate for IHT purposes. As the business grows, the loan will become a smaller proportion of it, which means the benefits of IHT increase over time.

Instead of or possibly in addition to a loan, it is also possible to create redeemable preference shares when the company is incorporated. These shares do not require distributable returns and are generally treated as a capital gains tax position for the shareholder, which can be quite small. Rosenbloom says callable preferred shares achieve a similar result to a loan, but are harder to understand and tend to be less popular. She adds that they can be expensive to set up.

pay a salary

You can also choose to pay a child a salary from the family investment company. This can help them when applying for a mortgage, for example. But those who go this route must be careful and involve the child in the management of the company. In short: if you pay more than the business wage for the work done, you risk the whole business falling into your estate for IHT purposes. “On a practical level, I would discourage people from taking a salary,” Rosenbloom says. Salaries also increase administrative costs as they require the creation of a wage bill and national insurance payments.

Redemption of shares/liquidation of the company

If one of the shareholders wants to extract their money from the company, this could be done through a buyback of their shares by the company. If you do, go to HMRC for clearance to ensure that the surrender value will be treated as a capital value rather than an income distribution to reduce your tax liability. You must also do this if the entire company is liquidated.

There are also targeted anti-avoidance rules to consider. If you extract money from a family business and immediately set up your own separate family business, HMRC may say the proceeds should have been treated as a distribution of income rather than capital. However, if you’re buying a home with the proceeds, that’s likely to be acceptable, according to Wood.

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