James Bailey explains how redeemable preference shares can solve an inheritance tax problem associated with directors’ loan accounts.
Transferring a partnership or a sole trader’s business into a limited company can provide a number of tax planning opportunities, including the lower (20%) rate of corporation tax on profits, as compared to 42% or 47% for income tax and National Insurance contributions (NICs) on individuals. Typically, the strategy involves ‘selling’ the business to the company (with entrepreneurs’ relief reducing the rate of capital gains tax on any gain on the sale to 10%).
The company does not pay cash; instead, a director’s loan account (DLA) is established, which means the company owes the purchase price to the director as a debt which it can repay as and when cash flow allows. There are no tax consequences for the director on taking these repayments, so effectively he will enjoy a holiday from paying income tax until his DLA has been fully repaid.
Inheritance tax problem
There is one downside to this strategy, however. Before the incorporation, the sole trader or partner owned an interest in a business, which (provided it was a trading business) would probably have qualified for business property relief from inheritance tax (IHT). After the incorporation, a significant proportion of the value of the business is now in the form of the DLA, and a DLA does not qualify for business property relief for IHT purposes.
Until the DLA has been repaid, therefore, there is an exposure to IHT which can be a worry, particularly if any of the proprietors is elderly or in poor health. The interest in the old unincorporated business was effectively exempt from IHT on the death of the sole trader or partner, but the DLA is no different from an account with a high street bank – it is potentially liable to IHT at 40%.
A solution?
Redeemable preference shares (‘Prefs’) can provide a solution to this problem. A Pref is a particular type of share capital which, unlike ordinary shares in a company, can be repaid by the company as and when the terms of the Prefs indicate. The ‘preference’ part of the name refers to the fact that a Pref has a prior entitlement to a share of profit – usually expressed as a percentage of its face value – but this percentage can be set as low as you like. A Pref is repayable at its face value, regardless of whether the company has increased in value since it was issued or not, whereas an ordinary share represents a share of the total value of the company and so its value will fluctuate according to the company’s fortunes.
Repaying ordinary shares can be a cumbersome business, and unless the same proportion is repaid to every shareholder, it will also affect the proportion in which the shareholders own the company. As Prefs are really a debt by another name (significantly, Prefs are shown as creditors in a company balance sheet, not as share capital), repaying them does not alter the proportions in which the company is owned.
Although Prefs are not treated as part of a company’s share capital in its accounts, or for some tax purposes, they are ‘shares’ for the purpose of IHT. This means that in a case where a business has been ‘sold’ to the limited company in exchange for Prefs, the Prefs will be ‘replacement property’ for the purposes of IHT, meaning that they can immediately qualify for business property relief. The normal two year wait for business property to qualify for business property relief does not apply.
Practical Tip :
IHT is a potential problem when moving a business into a limited company. Prefs provide a solution whilst retaining almost all the flexibility of a DLA.
