News and views from Lane-Smith & Shindler

Succession planning might be defined as the process whereby someone arranges to transfer their assets to the next generation in an orderly and tax-efficient way.  Succession planning is not a big issue for most people, who simply leave whatever they have when they die to their spouse and/or children.  However, this is not always considered appropriate, particularly if large sums of money are involved, or if the assets being given away include a family business which is worth more as a whole than if it is divided up. 

Traditionally, the solution to this problem has been to create a family trust as a means of splitting the management and control of an asset from its ownership.  Ownership would rest with the beneficiaries of the trust but management and control of the asset would reside with trustees appointed for the purposes.  The trustees might also have the power to vary the entitlements of the beneficiaries to take into account future changes in circumstances. 

Since March 2006, dispositions into trust generally give rise to an IHT charge, whether or not the disposition occurs on death.   This is a particular problem if a person wants to give assets into trust during their lifetime, for example with a view to saving inheritance tax when they die. 

In recent years, partnership arrangements have been used as a substitute for trusts to get around this problem.  The partnership assets would be owned by the partners, but management and control of the assets would reside with a specially appointed ‘managing partner’.  In this way, the partnership was structured in a similar way to a company, with partners acting in the role of shareholders, and the managing partner acting like the managing director. 

This being the case, why use a partnership instead of a company?  The main reason is to do with income tax and capital gains tax.  Partnerships are ‘transparent’ for tax purposes i.e. the income and capital gains of the partnership are subject to tax on the individual partners.  By contrast, companies are ‘opaque’ for tax purposes – the company pays tax on any income and capital gains and there is a further tax charge to pay when shareholders receive a dividend or a payment on redemption of their shares.

Whether or not a partnership pays less tax than an equivalent company depends on an assessment of a number of different factors including the type of income that will be received, the mixture of income vs. gains, the circumstances of the beneficial owners, and the amount that will be paid to the beneficial owners as opposed to the amount that will be retained within the structure.  It is the sort of question that accountants like to spend a lot of time considering with the assistance of spreadsheets.  Suffice to say that to date the partnership has looked relatively more attractive than the company in the majority of cases.

That situation is likely to change.  The capital gains tax rate for individuals is going up (for higher earners).  Corporation tax rates are coming down.  In addition there is the new 50% income tax rate for very high earners.

In 2006, partnerships were the new trusts.  This year, companies are the new partnerships.

It is apparent that an early casualty of the Conservatives’ coalition deal with the Liberal Democrats has been their manifesto pledge to increase the inheritance tax allowance (or ‘nil-rate band’) to £1m.

The pledge was originally made in 2007 when the world was a very different place.  More recently, the pledge has been used by the Conservatives’ opponents to make them look out of touch with ordinary people.  An individual allowance of £1m equates to a joint allowance for married couples of £2m.  During the election debates Gordon Brown made reference more than once to the Conservatives being more interested in helping ‘double millionaires’ than ordinary families.  There may be a suspicion therefore that the Conservatives were not entirely unhappy about dropping the proposal.

The inheritance tax allowance is currently set at £325,000 (equivalent to a joint allowance of £650,000 for married couples and civil partners).  In his last Budget before the election, Alistair Darling indicated that there would be no increase in the allowance until 6 April 2015.  Clearly, that may change but the best that can probably be hoped for over the next five years is a small annual increase in line with inflation. 

After deducting the nil-rate band, inheritance tax is levied at a flat rate of 40% so the amount due quickly adds up.  A married couple with joint assets worth £1m face an inheritance tax liability (payable on the death of the second person to die) of £140,000.  A married couple with joint assets of £2m face a liability of £540,000.

Roy Jenkins once famously described inheritance tax as a “voluntary tax”.  That may be an over-simplification, however inheritance tax is certainly easier to avoid than other taxes provided you don’t leave it too late.  There is anecdotal evidence that the prospect of a significant increase in the nil-rate band has caused some moderately well-off people to defer steps that they might otherwise have taken to reduce their inheritance tax liability.  The position now is much clearer.  Waiting and ‘hoping for the best’ is no longer a sensible option and people who have put off making the necessary arrangements need to press ahead now without further delay.

A trust can be summarised as an arrangement whereby person A gives assets to persons B and C who together promise to deal with them for the benefit of persons D and E.  If the trust is made by a person during their life the arrangement is usually documented in a document called a trust deed.  Someone can also make a trust in their will.

The trust can take effect in a number of different ways.  For example, the arrangement may be for person D to receive the income from the trust assets during his or her life, subject to which the trust assets will pass to person E.  Or the trustees may be given discretion to pay income and capital at any time to any one or more members of a class of potential beneficiaries (for example the children and grandchildren of the person who provided the assets to set up the trust). 

There have always been two important restrictions on the nature of the arrangements allowed, designed to ensure that no-one could put assets in a trust indefinitely.  The so-called ‘rule against perpetuities’ means that a trust must generally come to an end after 80 years, and the ‘rule against excessive accumulations’ restricts to 21 years the period during which trustees can decide to accumulate income and add it to trust capital instead of paying it to a trust beneficiary.  Charitable trusts are not subject to these rules.

The Perpetuities and Accumulations Act 2009 will come into force on 6 April 2010 and makes the rules much more flexible.  It will introduce a longer perpetuity period of 125 years and abolish restrictions on accumulating income.  However the new rules will only apply to trusts made on or after 6 April 2010, and to wills signed on or after that date.  Existing trusts and wills are not affected.

Anyone who is thinking of making a trust, or of signing a will that includes a trust, might want to delay doing so until 6 April in order to take advantage of the new provisions.  Some people may want to sign a new will to replace an existing will in order to take advantage of the new provisions.  Trustees of existing trusts are however not able to bring themselves easily within the new regime.

We are now updating our standard documents to take account of the new rules.

Apologies to the casual reader because this post is fairly technical. It will be interesting to people who advise on trust taxation however and anyone else who has heard of the legal case referred to as Howell v Trippier.

This firm has recently handled a case in which, in the last couple of days, the court has ruled that scrip dividends received by trustees of a discretionary settlement have the nature of income rather than capital and that in the absence of any positive decision by the trustees to accumulate that income and add it to the capital of the trust fund, the income (and the proceeds that represent it) are not subject to inheritance tax.

The case will be reported in due course under the name of Pierce v Wood.  However you read about it here first!

The subject of the 50% top rate of income tax is back in the headlines after Mr Cameron suggested he might get rid of it if it doesn’t raise any additional revenue.  It is interesting to see the amount of ignorance among members of the public who think that higher rates of tax necessarily raise extra revenue.  Sometimes the reverse is true.

Who will pay the higher rate?  Not those who derive their income from quoted investments; there are a number of ways to shelter investment returns from income tax, either through deferral vehicles (investment bonds or gross roll up funds) or by investing for capital growth rather than income.  The main target of the higher tax rate therefore would appear to be high earners such as bankers and businessmen.  After factoring in national insurance contributions the top rate of tax on earnings will be well in excess of 50%.  Avoiding this tax will be difficult, especially given that there are already tight restrictions on pension contributions.  Other than moving abroad or taking a sabbatical, what can be done?

At this point I will briefly mention that there are some ’schemes’ in the market, promoted from the Isle of Man, which purport to enable professional contractors and the like to keep up to 90% of their earnings after tax.  I make no comment here on the efficacy of such schemes although they do bring to mind the old adage that “if it seems too good to be true, it usually is!”

There is another group of people for whom careful planning may yield worthwhile results, without the artificiality of employing yourself via an Isle of Man company.  I am thinking here about owner-managed companies.  In a good year, the directors have a choice.  They can pay themselves a bonus, declare a dividend, or leave surplus cash in the company.  They can, in effect, decide whether to receive their income as earned income or investment income and can also decide to some extent to defer their income to a later date.

The decision whether to pay a bonus, or a dividend, needs to be arrived at after some careful calculations but, unfortunately, whichever route is chosen normally involves a significant tax charge.  Private company shares are unlike quoted securities in that there are restictions on ’wrapping’ private company shares in a tax efficient way (although, as always, there may be ways around the restrictions).  The obvious way to pay a lower rate of tax therefore, is to leave money in the company with a view to a liquidation or sale, triggering capital gains taxable at 18% (or 10%, if entrepreneurs relief is available).

But there is an alternative that may be attractive, particularly to people with young grandchildren.  Everyone, no matter how young, is subject to income tax on an individual basis.  By careful planning, dividends can be diverted to the grandchildren and, provided the amount is less than £39,000 each year, no tax will be payable.  The money could be used to pay school or university fees, or put by as a deposit for a house.  The grandchild can even invest in a stakeholder pension, with the benefit of income tax relief!