THE POST-INCORPORATION DIRECTORS LOAN ACCOUNT – A POTENTIAL IHT PROBLEM?
The Incorporation Boom
In the late 2000s and early 2010s, incorporation was for many sole traders and partnerships running businesses, something of a “no-brainer”.
There were numerous reasons for this. Firstly, from the 2008/9 tax year onwards, capital gains tax (“CGT”) rates were historically low in any event, and for individuals disposing of certain business assets, the availability of Entrepreneur’s Relief (“ER”) meant that the effective rate of CGT was as low as 10%. (Unfortunately, ER is not now available on a sale of goodwill to a company connected with the vendor so it is no longer as attractive an option.)
Secondly, the tax rates paid by companies on their profits were also relatively low and certainly much lower than the income tax rates suffered by sole traders and partnerships.
Thirdly, the largest single asset of most of these businesses was goodwill built up over many years and this was a particular incentive to incorporation as the newly incorporated company could also reduce taxable profits by taking a tax deduction over time for the goodwill it was purchasing from the partnership or sole trader. (It is not now possible to amortise the value of purchased goodwill for corporation tax purposes.)
Unsurprisingly, the tax attractions of incorporation at the time were almost irresistible for many unincorporated businesses.
How it was done
The usual method of incorporation was, broadly, for the assets of the unincorporated business, including goodwill, to be sold to a brand new limited company at market value. This created a capital gain but, in most instances, this was taxed at a mere 10% after ER. The 10% tax was paid but the rest of the price paid by the company was left outstanding on loan account, where it could be withdrawn by the seller, now a director of the new company, tax- and NIC-free.
The IHT sting in the tail
Before incorporation, the likelihood was that the whole value of the business would have been completely free of Inheritance Tax (“IHT”) in the event of the death of the proprietor or partner by virtue of Business Property Relief (“BPR”) at 100%.
The IHT position often changed drastically on incorporation. However advantageous the incorporation might have been from an income tax, NIC and CGT perspective, the value now represented by the directors loan account (“DLA”) no longer qualified for any BPR at all, leading to a significant potential IHT exposure. In many instances, the value of the shares now held in the company was minuscule compared to the value of the DLA with potentially disastrous IHT consequences.
A solution to the IHT problem?
One potential solution is to consider using the DLA balance, or part of it, to subscribe for redeemable preference shares in the new company. Redeemable preference shares, once held for the minimum holding period of two years, will qualify for 100% BPR just like the company’s ordinary shares. They can also be redeemed out of the company’s profits (or those of any new share issue) as and when these permit. If the necessary board resolutions, minutes and share issue documents are correctly drafted, it should not be significantly more difficult to redeem the preference shares than it would be to draw on the directors loan account.