Trusts are an important staple of the estate planning toolkit. However increases to the complexity and cost of their taxation and reporting requirements in recent years, combined with some negative media attention, means families are increasingly looking for alternative structures to govern the transition of wealth and its management to the next generation. One such alternative model is the family investment company (FIC). Whilst the concept of a FIC is not new; being a company established to hold and build family investments, awareness of its estate planning advantages through bespoke articles and different share classes is growing. This briefing introduces a FIC’s key features and its potential as an addition, or alternative, to a trust.
Put simply, a trust is the transfer of assets to legal owners to hold them as 'trustees', with instructions as to how those assets (called the ‘trust fund’) are to be used to benefit a certain class of people. This may be, for example, a grandparent (the ‘settlor’) giving their children an investment portfolio to hold for the benefit of their grandchildren.
Whilst the legal owners of the trust fund are the trustees, the settlor can, to a certain extent, retain an element of oversight and control. The trust deed, which is effectively the rulebook of the trust, can either set out quite rigidly how the assets are to be dealt with, who will benefit from them and to what extent, or it can give the trustees wide-ranging discretionary powers to deal with them in the way they think best. This flexibility enables them to take into account each beneficiary’s individual needs and circumstances and the changing situation of the family in light of the settlor's wishes and his or her intention behind establishing the trust.
As well as offering this protective environment for holding assets for the family, trusts can also offer significant tax benefits and therefore have a key place in estate planning. In particular, trusts can carry advantages for income tax, capital gains tax and inheritance tax. For example, a trust established during a person's lifetime (certain trusts created under wills are taxed differently and, depending on the circumstances, more favourably) is a taxable entity in its own right for inheritance tax (IHT) purposes and so, if a person were to survive seven years from the date he or she established it (and did not continue to benefit from the assets given away), its value would fall outside of the amount on which IHT is calculated for their estate on their death, without necessarily increasing the size of any of the beneficiaries’ estates for IHT purposes.
Trusts established for ‘minors’ (children under 18) by grandparents can be extremely useful for making gifts in a protective environment that carries income tax benefits. Whilst any income the trust funds generate would be subject to income tax at the highest rate, if any of that income is paid to or used to benefit the children, they may be able to claim a partial or full refund on the tax paid by the trustees. This income tax treatment is not available for trusts established by parents until their children reach 18, as before that age the parent would be subject to income tax on the trust fund income at their own marginal rate.
There are, however, potential tax disadvantages for settling assets on trust during one's lifetime. Most trusts established in this way are taxed under what is known as the ‘relevant property regime’, which carries an IHT ‘entry charge’ of 20% on the value settled to the extent that it exceeds the settlor’s available nil rate band (which is currently £325,000). They are also subject to two further IHT charges during their lifetime: ‘exit charges’ (when capital is appointed from the trust) and an ‘anniversary charge’ every 10 years since its creation. The rate of tax applied is up to 6% of the value of the funds leaving the trust (in the case of an exit) and on the value of the trust fund at the time (for an anniversary charge).
There are also strict anti-avoidance rules that prevent a settlor from making an effective gift of the trust assets if they retain any interest in them, or if the settlor is capable of benefitting the trust at all. If they 'reserve a benefit' in the trust in this way, its value would remain part of their estate for IHT purposes.
Notwithstanding the relevant property regime tax on lifetime trusts, they remain popular planning tools for families, particularly where the value settled is under the nil rate band and so would not be of an amount sufficient to trigger an IHT charge in the first ten years, and potentially beyond (depending on how the value of the trust fund compares to the nil rate band in place at that time). For large value trusts, there may however be significant charges to pay for the ongoing protective environment they offer, notwithstanding that in many cases the rationale for the trust is not to save tax but to preserve and safeguard assets for the family.
A FIC is essentially a private limited company with bespoke articles of association (in the same way as a trust deed, the articles are effectively the rulebook for the company) to make it suitable to operate in a family estate planning context. There will also often be a separate shareholders’ agreement; a private contractual document between the shareholders. The shareholders of the company will be family members and possibly a family trust.
The articles, which are registered with Companies House and are a public document, set out the respective rights and interests attaching to the different shareholdings in the company. These share classes will be held by different family members in accordance with their role in, and intended rights in respect of, the company and the investments it holds. This arrangement is often referred to as creating 'alphabet shares' and enables the family members to have different levels of control over company decisions, rights to receive dividends and entitlements to the capital value of the company. Parents can transfer value and responsibility to their children in stages through the company structure, whilst retaining the oversight and control of the company.
The articles can also include provisions that protect the shares in certain circumstances. For example, to prevent shares being transferred outside of the family by setting out pre-emption rights on any sale or transfer, and so restricting the shareholders to immediate family or family trusts. They can also set out a basis and mechanism for valuing the shares in certain circumstances, which may assist if a family dispute were to arise in future.
In this way, a FIC can be a flexible vehicle for parents to establish a structure to manage the investment of family wealth and the eventual transfer of its value to the next generation in a controlled manner. For tax purposes, the timing of any gifts they make will be when value and rights are moved from them to their children (or other family members or trusts). This can be planned in a staged manner, to carefully control the timing and value that is transferred and the tax treatment of doing so.
Whilst invested in the company, the senior shareholders (often the parents) can withdraw funds if needed and in accordance with the entitlement of their shareholdings. A common means of funding such companies initially (and thereby establishing the value the company has available to invest) is by a loan from the parents as well as their subscription for shares. This means that, when required in the future, cash can be extracted from the company by way of a repayment of loan, rather than in the form of a dividend, and therefore is not subject to income tax.
The tax regime applicable to FICs might offer some advantages over a lifetime trust where the value it contains is substantial. As companies, FICs are subject to corporation tax on the income they receive, which is likely to be at a lower rate than the personal marginal income tax rates (assuming that the shareholders are higher rate tax payers). Furthermore, with effect from 1 July 2009, most dividends received by a UK company are exempt from corporation tax. The beneficial dividend rates for companies effectively facilitate the growth roll-up of dividend income by deferring taxation until a distribution is made from the company. If the FIC holds an investment portfolio of UK companies, this would be an effective means of estate planning.
For other investments held by a FIC, the sting in the tail to using a company structure is the potential for double taxation when profits are extracted from the company (corporation tax having been paid on the income when received, and then income tax due on a payment from company to shareholder in the form of a dividend). This can be managed to an extent through the investments the company holds and the timing of distributions (for example, payments to shareholders in years when they are subject to a lower rate of income tax).There are other practical advantages, depending on the family’s approach to investments, as the duties of a director to manage company assets are different to the fiduciary duties of a trustee in respect of a trust fund. Broadly speaking, the FIC’s directors, who will usually be the parents initially, are able to take greater risks from an investment strategy perspective than trustees might be comfortable with (there are particularly onerous duties on trustees in respect of the investment decisions they can make).
A full comparison of the alternative structures of trusts and FICs would include the relative privacy they offer for the family, registration requirements, annual administration and tax compliance. We advise clients regularly on how these will fit with their circumstances and objectives.
The best strategy for a family can often involve combining the structures of a FIC and a trust. As one of the benefits of using a FIC is the ability to separate out the rights and powers in the company through alphabet shares, placing one of those share classes into a trust can create tax efficiencies for the future, and offer a protective environment for the shares for young or vulnerable family members. For example, for parents who want to gift shares but continue to have oversight of the revenue they produce, they could consider placing those shares into a trust so that, as trustees, they would decide how and when the funds were used for the beneficiaries.
In the ever changing landscape of personal taxation and compliance, and with every family having unique dynamics and objectives, the structures and vehicles available to meet a family’s estate planning needs are also evolving. Whilst trusts remain a useful and popular means of gifting and family wealth governance, other models such as FICs are becoming popular as alternatives or additions to trusts. The best structure for the family needs to be considered carefully and established in the correct way. Professional advice at the outset and throughout its lifetime is essential.
This article was published in a Charles Stanley inherited wealth briefing in March 2019.