Understanding “Funny Shares” to Transfer Wealth More Tax Efficiently

By Toby Hermitage, Tax Partner at Carter Backer Winter LLP

One of the challenges we face today is passing on accumulated value in investment and property companies to the next generation tax efficiently. In many cases, the shares in these companies are held by older members of the family who fear that HMRC will take a substantial bite out of these hard-earned assets when they pass away.

Without the benefit of any relief from Inheritance Tax (IHT), in most cases this bite will equate to 40% of the accumulated value at the date of death. To further complicate matters, this will, in many cases, force the sale and distribution of assets from the company to settle the IHT liabilities as they arise.

Selling underlying assets triggers corporation tax charges, and once the cash realisations are extracted from the company, this will also trigger income tax charges. Put simply, this means total tax liabilities, as a proportion of the value of the underlying assets, could become sizeable. It may also lead to assets being sold at an unsuitable time when their value is suppressed or over-inflated, which, depending on the circumstances, can compound the problem further.

Reducing IHT liabilities

For IHT purposes, the obvious solution is for the older generation to pass on their shares to the next generation and to survive the transfer by seven years to remove the IHT charge completely. Whilst extremely efficient for IHT purposes, the downside of this option is that it triggers a capital gains tax charge of 20% on the net gain, rather than the gross value.

Although this represents a better outcome than IHT at 40% on the gross value, the immediacy of this tax liability is a clear shortcoming of this option. Another disadvantage is that many individuals may need the income or capital value contained within these companies to fund their retirement.

A better way

Given the choice of a lifetime transfer with an immediate 20% tax charge or waiting until death and suffering a charge at 40%, many people seek a more creative third way.

One option is to create new classes of shares or “funny shares” that carry bespoke rights to the income and capital of the company. The design of these rights can be complex, but these shares can allow future increases in capital value or future income rights to pass into the hands of the next generation or even the generation following that, with little or no tax arising at the time this is done.

These new shares would normally be wholly excluded from benefiting from the current value of the company, reducing their value. Depending on the specific rights attributed to these new shares, their potential value could be reduced to a nominal amount. Shares from this new class would subsequently be acquired at market value by the next generation. That said; particular care must be taken if some of these individuals are minors.

By creating “funny shares”, the value of the existing shares can be capped at their current value, giving some level of certainty over potential IHT exposures at a later date, without causing hardship to the older members of the family who still need access to the income or capital value of the company.

Rights divisions

It’s also possible to split the rights of the existing shares to separate the income and capital elements in terms of both the amount and time. This can then make passing on some or all of the shares within a lifetime considerably easier to manage as the older generation can retain the aspects that they require and potentially pass on or even sell those that they don’t. This division will lower the value of each of these individual aspects, reducing and allowing for control over the timing of lifetime capital gains tax liabilities to be exercised.

Bio

Toby Hermitage is a Tax Partner at London accountants, tax and business advisers CBW. He has specialised in providing bespoke tax planning to owner-managed businesses and their owners for almost 20 years. For more guidance on transferring wealth tax efficiently via shares, contact Toby on (0)20 7309 3972 or email Toby.Hermitage@cbw.co.uk