Family trusts have featured strongly in estate planning for many years, but more recently the family investment company has come to light for its own tax advantages. We set out their respective pros and cons, to help you decide which would work best for you.
A Family Investment Company (FIC) is a private limited company with bespoke articles of association, where the shareholders are family members. The articles are drafted to ensure the company’s operating rules are appropriate for family estate planning and there is usually a separate agreement between the shareholders.
Family members would typically hold different classes of shares within the company (known as alphabet shares). Different share levels allow individual family members to have varying levels of control over the company, different rights to dividends and entitlements to the company’s capital.
FIC – the pros
The person setting up the FIC can keep control of the assets. This is achieved by granting the person voting rights, but no rights to the capital. Without being a beneficial owner, after seven years the company’s assets would fall outside of their estate for inheritance tax (IHT) purposes.
Crucially, transferring cash into a FIC is not subject to the IHT entry charge at 20%, if the cash exceeds the nil rate band of £325,000 (if available). If someone plans on transferring funds over £325,000 but still wants to maintain some control then a FIC offers more favourable tax treatment. Profit from the investments are subject to corporation tax at 17% (as at 1 April 2020), lower than higher rate income tax.
A FIC can be a flexible, tax-efficient vehicle to manage the transition of family wealth from one generation to the next.
FIC – the cons
FICs can be expensive to set up as they usually involve both corporate and private client solicitors and accountants.
There are ongoing administrative burdens, such as yearly confirmation statements and accounts which need to be filed at Companies House, with the associated cost of a solicitor/accountant to prepare them.
A FIC’s governing documents will be publicly available through Companies House. The lack of privacy may not be a concern, but should be noted.
If property goes into the FIC it may trigger a Capital Gains Tax (CGT) Charge and stamp duty. Dividends, which distribute the profits of the FIC, could be taxed twice; Corporation Tax (CT) on the company itself and Income Tax which would need to be declared by the shareholder on a self-assessment tax return.
Possible UK tax changes may reduce the current tax benefits of a FIC. There is speculation that the Government may increase both CT and CGT (both currently at low rates) to help pay for the Covid-19 crisis. Although nothing has yet been confirmed a recent CGT report commissioned by the Chancellor has indeed recommended increasing CGT. There is also the possibility a future government may introduce legislation which would effectively remove any real benefit of having a FIC.
Using a trust for estate planning – the pros
The person putting assets into a trust (the Settlor) can retain control of the trust assets as long as they don’t retain a benefit (e.g. gifting a property into a trust but still living in it without paying market rent).
Trusts can be flexible; for instance, by giving the trustees the power to appoint capital to beneficiaries if they decided to do so. The Settlor could be one of the trustees, so they could have a say in what goes on.
If the Settlor survives seven years from putting the assets into trust then this falls outside of their estate for IHT purposes. A taper applies if the Settlor dies before seven years has passed.
Under a discretionary trust, no IHT arises when a beneficiary dies. This is because no part of the trust fund is deemed to form part of the deceased beneficiary’s taxable estate.
Using a trust for estate planning – the cons
Whilst it is not necessarily a disadvantage, it’s worth noting that a discretionary trust is a taxpaying entity. Once it is constituted, i.e. holds assets, it will be subject to income tax on the income produced by the assets, capital gains tax on a disposal by the trustees, and inheritance tax.
There is an administrative burden of registering a trust (once constituted) with HMRC, and the trustees must file an annual Trust and Estate Tax Return and accounts with HMRC.
Unlike a FIC, if the transfer into trust exceeds the value of the nil rate band (currently £325,000) after taking into account any other chargeable transfers (gifts made into trust) made in the previous seven years, tax is charged at the rate of 20%, i.e. half the rate applicable on death, assuming that the trustees pay the tax. Unlike a FIC, this limits what you can put into a trust without it triggering an immediate tax charge.
CGT may be payable if the trustees sell assets that have risen in value whilst they have held them. Trustees have an allowance of half that of an individual (£6,150 for the 2020/21 tax year). However, the CGT tax-free allowance may be reduced if the trust’s settlor has set up more than one trust since 6 June 1978.
Trustees do not qualify for the dividend allowance, so will pay tax on all dividends depending on the tax band they fall within.
As the Settlor does relinquish ultimate control to the trustees, the choice of trustees is very important. If the relationship between the trustees and the Settlor breaks down it could lead to a dispute.
If a discretionary trust is expected to last for more than ten years, there will be a charge to IHT on the tenth anniversary, and each subsequent ten year anniversary. This applies if the value of the Trust property (together with the value of any property distributed in the preceding ten years) exceeds the nil rate band as at the anniversary date. Broadly speaking, current rules mean that the balance of value in excess of the nil rate band will be taxable at a flat rate of 6%. If funds are taken out of the Trust between ten-year anniversary dates, an exit charge is made at a proportion of the 6%, depending on how long it was since the last ten year anniversary.
Again, it is possible that the Government will overhaul the tax regime for trusts, rendering the tax reliefs and benefits less favourable overall. At this stage, it’s not possible to predict what the changes might be or when they will happen.
Making your choice
So, which is better – FIC or family trust? It isn’t possible to declare a clear winner; ultimately it will depend on personal circumstances, the value and nature of your estate and what you want your estate planning to achieve. Plus, of course, the current tax rules. To be certain your assets are distributed as you wish, and tax-effectively, up-to-date advice tailored specifically to you is essential.
You can read more about Family Investment Companies here.