How to prevent the Create, Consume and Destroy legacy

Date: 16 Aug 2011

Citywealth

Dhana Sabanathan, a solicitor in the tax and private client practices at Harbottle & Lewis, discusses how to preserve wealth for generations to come:

In the wealth planning business, the preservation of wealth for future generations is a significant driving force. However, it appears that in reality successful families often fall foul of the dictum that it takes one generation to create wealth, the second to consume it, and the third to destroy it. This negative view of wealth preservation has received statistical support with the recently published figure from research by business consultancy Barbara Hauser Associates that only six out of 100 family businesses survive into their third generation.

What is the solution? There is no guarantee that future generations will inherit a genuine passion for the family business or any particular financial acumen. However for many, the reward of hard work is the knowledge that future descendants will be able to benefit from their success.

Trusts are the most popular vehicle for succession planning, providing a level of protection and flexibility that is very attractive. There has been a trend towards increasing the age at which beneficiaries are entitled to receive distributions (to 35 or even 45) and for settlor’s letters of wishes to indicate more precisely the circumstances a settlor feels a distribution would be beneficial (for the purchase of a home, as opposed to the purchase of a new wardrobe). Trusts can offer a degree of asset protection, although it is important to note a UK court can look through trusts on divorce.

Furthermore, the fact that responsibility and discretion is often fully handed over to professional trustees, together with the potential for a significant “entry charge” to inheritance tax when settling assets on to trust, is a source of concern for some individuals. In such cases, where family members already actively manage a successful business, the alternative structure of a Family Limited Partnership (“FLP”) may be the solution.

FLPs fall outside trust law and are therefore controlled by the laws of contract. The structure allows an individual to retain control over the funds in the FLP but separate out the ownership of those funds. Therefore the relevant members of the family can continue to work and grow the family business, whilst letting other family members benefit from an interest in the income and capital. There is also the possibility to gradually enrol the more junior limited partners in the business (for example the members of the second generation who take an interest in working for the business), and increase their levels of financial responsibility.

An FLP is a partnership consisting of at least one “general partner” and at least one limited liability partner. The general partner controls the day to day management of the partnership, has unlimited liability and will generally have a fairly small capital and income entitlement under the partnership. It is possible to in effect limit the liability of the general partner by using a group company structure. The limited partners have a larger capital and income entitlement but do not take part in the day to day management of the business.

An FLP will be a collective investment scheme, undertaking a regulated activity. It is therefore necessary to have an FSA authorised operator and investment manager to control the regulated management of the business. The cost of meeting this requirement means that an FLP is normally only a viable structure for family businesses above a certain value.

Since 2006, there has been an immediate 20 percent inheritance tax liability arising on transfers onto discretionary trusts by UK domiciled individuals for assets (that do not benefit from any relief or exemption) above the value of the nil rate band (currently ¬£325,000). This then increases to 40 percent if the transferor dies within seven years. There are also exit charges and 10 year “anniversary” charges to consider. Furthermore, any income arising in a discretionary trust is currently taxed at 50 percent, even if the trust produces very little income.

In contrast, when the FLP is set up, the transfer of assets into the FLP is treated as a Potentially Exempt Transfer (“PET”), so there is no immediate inheritance tax liability, even if the value of the transfer is greater than the current nil rate band. If the transferor of the assets survives a further seven years, there will be no IHT to pay at all.

As the FLP is a partnership, it is tax transparent so each partner will be liable to tax at their own income tax rate on any income they receive from the partnership. This may be preferable to the 50 percent flat rate income tax liability of a discretionary trust. It is worth noting that while a partner is a minor, the tax will be levied on the parent donor at their tax rates. For family members who are university students or working but not yet higher rate tax payers, this ability to let them share in the profits of the family business can be tax efficient and reduce the exposure of the general partner to tax.

When the partnership is funded, it is possible there would be a capital gains tax liability on the disposal of the assets by the donor. However, the partnership can be funded with cash or potentially with business assets which benefit from “hold-over” relief. If there are any assets in the partnership which appreciate in value, upon a chargeable gain arising, each individual partner will be liable to capital gains tax at the rate applicable to them.

Although yet to be tested in the family courts, it is possible that an FLP will provide asset protection on divorce, as it is difficult for the Courts to change a partnership agreement which has been carefully constructed. Furthermore, there is the potential to include a provision in the partnership agreement that a partner may be disqualified from the partnership if they are declared bankrupt, providing a further level of asset protection.

Whilst FLPs are generally seen as less flexible than traditional trusts in terms of responding to any changes in family circumstances and may incur higher administration costs, the structure has advantages from an inheritance tax and income tax perspective, and allows the relevant family member (the general partner) to retain the day to day control of the business.