How to run a family business tax-efficiently

Running a family business isn’t always straightforward because of the relationships involved. Families should be open about their goals and expectations for the business, make the most of the tax reliefs available and plan well in advance for when it passes to the next generation, but this doesn’t always happen. Simon Martin, chartered financial planner and tax consultant at St James’s Place, says that, on average, family businesses tend not to be good at financial and tax planning, particularly when they are small. “They are often built around some people in the family being very good at something [for example, being] architects [or] running a bakery,” he explains. But “they don’t spend much time thinking about the structure of their business”.

Pay structure and tax efficiency are two areas that can often be improved. Work out the best possible combination of salary, dividends and pension contributions to pay yourself and the family members who work with you, depending on your business’s profits and income needs. This especially applies to spouses but can include adult children, taking advantage of all your combined allowances including the personal allowance for income tax, dividend allowance and pension allowance. “Make sure that as a family unit you are using everything that’s available,” adds Martin – as well as reporting all your allowable expenses.

Keep your personal and business finances separate. Susie Mullin, partner at Blick Rothenberg, says that a mistake people often make when running a family business is treating it almost like a bank account rather than a separate entity, which can create tax complications. For example, a property you intend to live in should not be purchased through your business.

More broadly, think about how family dynamics impact the way the business is run. If the business has been around for long, it may have a number of shareholders, not all of whom necessarily work within it. Laura Hayward, tax partner at Evelyn Partners, says that this can create tensions, for example when working family members want to reinvest in the business to grow it and non-working shareholders would prefer to protect the consistent dividends they receive from it.

The lack of a shared purpose is a common problem, as is the issue of skill gaps. “Family businesses employ family members and [they] can find themselves in roles that they are not necessarily trained for or that it’s not in their personality to do,” says Hayward. So you may need to look outside the family to fill those gaps.

 

Diversifying your wealth

Having the whole family depend on the same source of wealth and income is a pretty big risk, so try to diversify this. A first basic step is for all family members to save in pensions. Contributions to these are tax-efficient and separate from your business finances, so if something goes wrong with the business, pensions can act as a cushion.

Other personal investments, for example within an individual savings account (Isa), can fulfil a similar purpose and are more readily accessible if you are still far from pension age. Ideally, you should build those gradually over the years as extracting a big sum of cash from the business in one go can result in a hefty tax bill.

If you are in the process of growing your business, you may be reluctant to take out more cash than you strictly need. A way around this is to bring in external investors and free up some cash that can then be used for other investments. Family investment companies can be a tax-efficient way of structuring the investments. Their structure is similar to that of a regular business but their purpose is to invest rather than trade, and family members can hold shares in and receive dividends from them.

Also, consider diversifying investments and income streams within the business, but be careful of how you structure investments because they can impact the business’s ability to qualify for certain tax reliefs.

 

Passing on a family business

Passing on a business to the next generation can be a delicate issue. Martin says that a conversation needs to happen early on within the family to see whether the next generation really has the aptitude and desire to run the business. That leaves plenty of time to decide on an alternative exit strategy if the answer turns out to be no.

A business can be passed on free of inheritance tax (IHT) if it qualifies for business relief. But you can’t claim business relief if the company “mainly deals with securities, stocks or shares, land or buildings, or making or holding investments. Sometimes you have both a trading element and a non-trading element of the family business, for example where profits have been used to acquire investment properties,” says Mullin. “That element of the business would not qualify for business relief. Sometimes this tarnishes the whole company such that business relief is not available at all.”

So check that your family business qualifies well in advance and ensure things don’t change as it grows.

You can also gift your business, or shares in it, to family members during your lifetime if you decide to step away from it. Gifts made more than seven years before your death do not count towards your estate for IHT purposes so can be a good way to pass on investment businesses. If you die within seven years of passing on a business the assets may still be IHT-free if they qualify for business relief.

Not all of the younger generations of your family might be interested in running the business, and some might only enjoy being involved with certain aspects or areas of it. So in some cases, it might make sense to demerge the business or have one child buy out the others. For example, Mullin currently works with two sisters in their late 50s who run a second-generation property business together. However, the next generation comprises seven people in total and the sisters are looking at splitting the business into two separate entities. “Asking two sisters to run a business together is very different to asking seven cousins to run a business together,” notes Mullin. But separating a business tax efficiently can be very complex so you may need to take advice on how to do it.

As a family, also think about worst-case scenarios well in advance. For example, “if a family member dies, is the rest of the family comfortable with their shares passing to a spouse who is not a bloodline family member? says Hayward. “Or should those shares go directly to the next generation? What if that spouse remarries?” Having early discussions or even putting formal governance in place, for example through a family charter with a dividend policy, can help secure an agreement on potential issues before they arise.