Are trusts an appropriate vehicle to hold shares in a family business?

Family businesses are rarely created with generational succession in mind. Businesses start small and develop over time. At some stage, the owners of a business may need to decide whether to sell up or to retain the business in the family and pass the shares on.

If the decision is to keep the business in the family for the next generation, thoughts will turn to how this succession is best achieved. Considerations will include asset protection, business management and decision making, as well as tax. An outright transfer of shares to the next generation has the attraction of simplicity but does not provide asset protection in the event of divorce or improvident behaviour. The company articles will require amendment if only family members own shares in future, with pre-emption provisions included. Transfers of shares between multiple family members will proliferate the ownership more widely, sharing voting control, which can make management and decision making more bureaucratic.

General tax considerations on transfer of shares

From an UK IHT perspective, an outright transfer has the advantage of being a potentially exempt transfer (PET) (IHTA 1984 s 3A) and therefore is not reportable or subject to tax provided the transferor lives seven calendar years from the gift, provided the donor does not reserve a benefit. This seven-year exemption for outright gifts applies regardless of whether the shares qualify for business relief as relevant business property within IHTA 1984 s 105(1). If the shares do qualify, then a death within the seven-year period will not give rise to an IHT charge provided the shares themselves are still owned by the recipient at the time of the death (and arguably regardless of whether the shares qualify for business property relief (BPR) at that later time – IHTA 1984 s 113A(3A)).

For UK CGT there is an immediate charge based on the value of the shares, which may be substantial. That charge can potentially be deferred by claiming CGT holdover relief to a UK resident recipient under TCGA 1992 s 165, although any the value of any assets not used for the purposes of a trade, profession or vocation carried on by the company will be excluded (TCGA 1992 Sch 7 para 7).

Family trusts

Utilising one or more family trusts to hold shares can be attractive as the trustees can include professionals, trusted friends or industry experts who can, as a shareholder body, have key decisions reserved to them to ensure a voting block is retained in trust ownership and the trustees can speak as a united voice for the family beneficiaries, acting in the beneficiaries’ best interests overall. If there is disagreement between family beneficiaries the trustees can act as a useful safeguard, balancing the needs of the family as a whole and acting prudently in the exercise of their powers and discretions.

Many multi-generational family businesses have the ultimate holding company share ownership controlled by a board of experienced trustees making decisions on capital allocation and dividend strategy and delegating the day-to-day running of the business to the operational board. In larger family businesses the trustees can collaborate with a family council that represents the wider interests of the family. The trust will only pay tax on dividends when they are received and the trustees then control the timing of how, and to whom, any dividends or capital receipts are distributed. There can be income tax benefits if income is streamed to lower rate taxpayers perhaps by granting them an income interest (interest in possession) in part or all of the trust fund, and thereby avoiding the need for the trustees to operate a tax pool.

What are the tax implications of transferring family business shares into trust?

The first consideration is how to transfer the shares into a trust in a tax efficient manner. Since changes introduced on 22 March 2006, transfers into trust generally attract an IHT charge of 20% to the extent the value transferred exceeds the nil rate band (currently £325,000). That is unless a relief applies. Therefore, it is only likely to be appropriate for family businesses to transfer their shares into trust if the shares qualify for 100% BPR so that the 20% ‘entry charge’ is relieved from IHT.

The shares will qualify for BPR if they have been owned by the transferor for at least two calendar years prior to the transfer and provided the business is wholly or mainly that of trading within the meaning of IHTA 1984 s 105(3) (see HMRC v A Brander [2010] UKUT 300 (TCC)). Care must be taken in relation to any excepted assets not used or required for business purposes (IHTA 1984 s 112(2) and Barclays Bank Trust Co Ltd v CIR [1998] SSCD 125). It is essential that the activities of the company are carefully assessed in advance of and at the moment of any transfer. If the family business consists of a group of companies, there may need to be a reorganisation to move any non-qualifying value (such as investment assets/subsidiaries) out of the group and care will need to be taken not to ensure that, where applicable, the replacement property provisions at IHTA 1984 s 107 are applied, so that the two year ownership criteria at IHTA 1984 s 106 is not compromised. Holding companies of trading subsidiaries should qualify providing their activities are mainly those associated with acting as a holding company (IHTA 1984 s 105(4)(d) and HMRC’s Shares and Assets Valuation Manual at SVM111190).

There should also be no immediate CGT charge on the transfer into trust if holdover relief is claimed, provided that the settlor of the trust, their spouse/civil partner and any minor children are not capable of benefitting from the trust. An advantage of using a non-settlor interested trust to hold the family business is that the transfer will qualify for holdover relief of the whole gain on the grounds the transfer is an occasion on which an IHT charge may arise (even if there is no actual IHT payable) under TCGA 1992 s 260 rather than because it is business property within TCGA 1992 s 165. As noted above, s 165 is rather more restrictive, as no relief is given for the proportion of assets which are not business assets (TCGA 1992 Sch 7 para 7). Gifting shares to trusts may therefore be preferable for succession planning than gifting shares outright if the business has ‘substantial’ non-trading assets.

Once the shares are in the trust, the trustees may be subject to IHT at a maximum rate of 6% on their value at each ten year anniversary (above any available nil rate band allowance). This is unless, when the shares are appointed out of the trust, BPR continues to apply at the occasion of the potential charge. It is therefore essential that BPR monitoring is continued throughout the ownership of the trust’s lifetime and always at least two years in advance of any exit or decennial charge.

Gift with reservation of benefit rules
A trap that owners need to be wary of is the potential application of the gift with reservation of benefit (GWR) rules (FA 1986 s 102). If the transferor is not excluded from potential benefit under the trust, then the shares will remain in their estate and potentially subject to IHT at 40% on their death, although in practice it is likely they may be excluded from benefit anyway in the trust drafting so that CGT holdover relief can be claimed.

Even if the transferor is excluded from benefitting from the trust, it will be necessary to continue to monitor whether the GWR rules apply. For instance, if the transferor remains a director of the company and receives a remuneration package, it is essential that the remuneration is proportionate on an arm’s length director’s agreement and regularly monitored (see HMRC’s Inheritance Tax Manual at IHTM14334). Practically, it may not matter if the shares are within the GWR regime if BPR is available when the transferor dies (or releases the reservation), but ultimately if the transferor can benefit from the settlement or may otherwise be said to be benefitting from the company, the potential availability of BPR will need to be regularly reviewed. If the transferor retains rights over the company that can impact the rights and value of the shares in the trust, perhaps in relation to dividends or dilution, this can be a reservation for IHT. Note that a further potential benefit of trusts for BPR qualifying property relates to anomalies within the clawback aggregation rules as compared to an outright transfer that can lead to additional IHT savings on death within seven years.

In addition to being an IHT tax-efficient method of holding a family business long term, trusts can be useful if a family business is ultimately going to be sold, as the shares can be transferred into the trust without IHT before sale, banking existing BPR reliefs (in case the law changes in the future). If the proceeds of sale of the business retained in trust, the proceeds will be subject to IHT at a maximum of 6% every ten years, whereas if the proceeds are in personal ownership they are subject to 40% IHT on death. Note that it is essential that the company is not in the process of being sold at the time of the transfer to trust, otherwise BPR can be denied (IHTA 1984 s 113).

Business asset disposal relief
A potential downside of a trust selling a family business is that a disposal by discretionary trust will not qualify for business asset disposal relief (BADR), which brings the CGT rate down from 20% to 10% on up to £1m of gain. If the trust is an interest in possession trust and the trust co-owns the shares in the life tenant’s personal trading company with the life tenant (with the life tenant owning at least 5%), BADR may be available on disposal of the trust’s shares subject to how much lifetime allowance the life tenant has left and assuming the life tenant was an officer or employee of that company broadly for a period of two years and had an interest in possession throughout the relevant two year period. The trust document should be flexible enough to allow the appointment of a life tenant should the circumstances prove beneficial, although care needs to be taken as to timing and nature of any restructuring as this is a complex relief to apply to trusts and has been the subject of much recent case law (see Skinner v HMRC [2022] EWCA Civ 1222 and Buckley v HMRC [2024] UKFTT 29 (TC)).

Holdover relief
When the shares or proceeds are appointed out of trust there may be an IHT exit charge (unless BPR applies at that point) and CGT holdover relief should again be available provided the recipient is UK resident. Further, if an individual recipient becomes non-UK resident within six years of the end of the tax year in which the disposal on which holdover relief was claimed, and still owns the asset at that time, the holdover relief can be clawed-back (TCGA 1992 s 168(1)). Care therefore needs to be taken where there are non-resident beneficiaries.

HMRC clearance
Finally, and helpfully, a clearance procedure is still available in relation to the availability of BPR. If there is genuine uncertainty as to if and how it applies and an immediate charge to IHT is about to/has arisen, clearance can be obtained from HMRC and can generally be relied on, provided the information given to HMRC was accurate, complete and the transaction proceeded exactly as described and is valid for six months. This can be a particularly useful tool for complex arrangements particularly where restructuring is envisaged prior to a transfer into trust.

There are some specific pitfalls to check, although neither are likely to apply in straightforward cases of transfers into trust. Following the recent case of HMRC v Vermilion Holdings [2023] UK SC 37, shares in a family company may be deemed to be employment-related securities even if they are not in fact acquired by reason of employment and so taxed as employment income, for instance if an individual receives shares in the family company of which they are a director otherwise than in the course of normal domestic, family or personal relationships. Where these rules are in point they can be complicated to apply and have ongoing implications. Further, where more complex rearrangements of the ownership of family companies is contemplated, thought may need to be given to the transactions in securities rules which characterises and taxes any gains realised on any consideration received for the transfer of the shares as income, when one of/the main purpose is to obtain a tax advantage by paying CGT rather than income tax. HMRC clearance can be obtained if necessary.

What happens next?

When considering the appropriate course of action in practical terms, advisers should keep the following considerations in mind:

• Carry out regular BPR audits of the business and considering the BPR impact of business diversification, sale or reconstruction.
• Weigh up the legal and implications of outright gifts of shares compared to transfers to trust. If a trust is an attractive option, consider the identity of the trustees and how they will interact with the holding company board and how information will flow and strategic decisions will be made, keeping in mind who has power to appoint trustees.
• Consider the treatment of loan balances within the group or loans to shareholders and the dividend policy and trustee distribution policy.
• Consider how articles need to be amended to cover ownership by trusts, including permitted transfer provisions and pre-emption procedure, etc.
• Consider the implications of a shareholder agreement or family constitution to govern how directors are appointed and who can work in the business.

This article was first published in the Tax Journal.