How To Avoid An Inheritance Tax (IHT) Trap When Incorporating Your Business
Take The Advice But Pay The Price?
If you are a profitable sole trader or partnership then I am sure your accountant will have mentioned the tax savings you could make from transferring your business to a Limited Company. In fact, I’d be surprised if they hadn’t mentioned it to you more than once.
Incorporating Your Business
Say Tim’s business has assets worth £100,000 but makes good profits and is therefore valued at £250,000.
If Tim ‘sells’ his business into a Limited Company for £250,000 then £150,000 will be goodwill and will (most likely) be purchased using a directors loan account. So in effect, the company owes the money to Tim.
There will be Capital Gains Tax to pay at a rate of 10% but Tim will then be able to draw down on his directors loan account tax free. It sounds great and it is, unless Tim dies with his directors loan account still unpaid.
IHT & Your Business
If Tim had remained unincorporated then his business would have qualified for Business Property Relief (BPR) which potentially reduces any inheritance tax due on the business to nil.
However, if Tim has a directors loan account then this will reduce the amount of BPR he can claim. So if Tim dies with the loan still owing then IHT would be due on £150,000. At 40% this adds a further £60,000 to the overall IHT liability of Tim’s estate!
What’s The Solution
The company could issue ordinary shares to the director for the value of his loan account. These would qualify for BPR but the whole point of incorporating was to take advantage of the ‘tax free’ income and it is a pretty complicated process to cancel the shares each time he wants some cash. This would be further complicated if there are other shareholders.
Instead, the company could issue redeemable preference shares. They are treated as shares for IHT purposes so would qualify for BPR but they are easily converted into cash.
Did You Know?
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