Retiring without IHT trap

April 25th 2024

You hold the main interest in a family-owned trading partnership and are planning to retire, selling your interest to your adult children. But you have been advised that this could lead to an inheritance tax (IHT) charge?  Partner Kenny Adamson advises.

Unincorporated traders
Business property relief (BPR) is an extremely valuable tax planning tool. BPR applies to the value of qualifying business property that is subject to a transfer of value. This includes both lifetime transfers, e.g. a settlement of shares into a trust, and property passing via the will following the owner’s death. For sole traders and partners approaching retirement, there are specific considerations that should be looked at.

Partnership shares
A partner’s interest in a trading partnership can qualify for BPR subject to the conditional requirements for the relief being met. One potential trap that should be looked at is whether the partnership agreement states that your personal representatives are obliged to sell their share to the remaining partners. If it does, no BPR is available as HMRC takes the view that this is a binding contract for sale. One of the conditions for BPR is that no such binding contract exists.

If you discover a selling clause like this, we would advise that the partners replace it with a cross option agreement instead. This achieves the same thing without losing the BPR entitlement.

If you retire from the partnership, BPR is lost immediately as you no longer have an interest in the business. Even if you do not withdraw your capital this is simply treated as a loan, i.e. an asset for inheritance tax (IHT) purposes.

If the remaining partners buy your share, there will potentially be capital gains tax to pay. Whatever is left over will simply be cash for IHT purposes, unless it is reinvested into assets qualifying for BPR, or another IHT relief.

One way to avoid losing the entitlement would be to remain in the partnership but withdraw from the decision-making process and only take a very small profit share, i.e. retirement in all but name.

However, you should ensure that only the profit-sharing ratio is changed, do not change the capital shares. Not only could this trigger a chargeable disposal (if there is an asset revaluation), but you will diminish the value of your share in the business, meaning the amount of BPR will decrease.

The downside to this approach is that you will remain jointly liable for the debts of the partnership.

Advice for sole traders
When a sole trader retires, the business simply ceases to exist, so BPR can’t apply, meaning an IHT liability can literally pop up overnight. One way around this would be to bring in a partner (ideally a descendant who will carry on the business), then reduce the profit share in the way described above. Another solution would be to incorporate, as the BPR would then apply to the shares and there would be no need to actively participate in running the business. This would work very well if, say, you appointed your son or daughter as the director to run the company, but retained 100% of the shares. The shares could then pass via the will with BPR applying to remove the IHT.

If you sell your interest in the business, an equivalent amount of cash will be liable to IHT. You can avoid this by withdrawing from the decision-making business of the partnership, and reducing the profit share, but you must ensure that you don’t amend the capital share. This will be covered by business property relief if the planning is implemented correctly.

Whilst all of the above makes perfect sense, business owners should be careful not to fall into the “surplus cash” tax trap when it comes to Inheritance Tax (IHT). The value of an interest or shares in a trading (as opposed to an investment) business will generally qualify for 100% Business Relief for IHT purposes provided that certain conditions, such as a two year ownership period, are satisfied. What many business owners don’t realise however is that there may be restrictions to the Business Relief available to the extent that the business holds “excepted assets”, the most common being surplus cash.

So what is considered “surplus”? Unhelpfully there is no magic formula, although it has been accepted as a broad rule of thumb that cash reserves of roughly 25% of annual turnover may be permissible. Each case is considered on its own merits. HMRC has confirmed that unless there is evidence that the cash has been earmarked for a specific business purpose, it is likely to be seen as surplus and Business Property Relief may be denied.

Our Tax department are more than happy to answer any futher questions you may have regarding Inheritance Tax and other related matters.  Please do contact us directly.

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