Q and A tax: Limited partnerships and IHT planning

By Mark Summers, Lisa-Jane Fawcett | 00:01:00 | 07 November 2008

Setting up a limited partnership can help clients mitigate IHT when passing on wealth through generations, write Mark Summers and Lisa-Jane Fawcett of Speechly Bircham.

Mr and Mrs Smith are in their late 60s and resident and domiciled in the UK. Mr Smith is in the fortunate position of having £10 million cash to spare, as he recently retired after selling his business.

The Smiths’ family home is worth £1.5 million and their pension income covers their modest living expenses. Daughter Jane is married with two children, aged eight and five. Son Bill was recently struck by love at first sight and married a showgirl while on holiday in Las Vegas. Youngest child Bob shows some entrepreneurial flair but as yet his big ideas have not resulted in much success.

When Mr Smith is mulling over his plans for his new-found wealth at the club, his friend is shocked that he has not thought about his inheritance tax (IHT) liability. The Smiths quickly arrange a meeting at our offices.

The tax man taketh

The couple are right to have asked for advice. For every pound their assets exceed their combined nil-rate band of £624,000, the tax man will take 40 pence when they die – which would result in a tax bill of more than £4.35 million.

First, they should have suitable wills. Not only does a will serve the crucial role of directing who should receive their assets when they are no longer alive, and when, but it also offers a one-off opportunity to save significant amounts of IHT. In particular, a properly structured will can pave the way for taking steps after the first death to save appreciable amounts of IHT on the family home.

However, more will need to be done to reduce the tax on the £10 million cash.

Giving gifts

What about lifetime giving? Mr and Mrs Smith’s family will be pleased to hear that the couple can give away as much as they like during their lifetimes without IHT consequences, provided they survive the gifts by seven years.

However, Jane’s children are too young to receive large sums of money and the Smiths pale at the thought of what Bill and Bob might do with the cash. They also feel that if they are making a generous gift, they would like some control over how the money is spent.

Trusts have been a popular vehicle for passing wealth down the generations while protecting assets, but Mr Smith’s friend told him that it is now impossible to make a trust without expensive tax charges. We explain that changes to the IHT legislation have made it harder to use trusts, but there are still opportunities to transfer assets to trust free of IHT:

Mr and Mrs Smith’s property does not qualify for agricultural or business property relief. They are capital rich but relatively income poor, so the surplus income trust is not appropriate.

They can set up nil-rate band trusts, but their combined nil-rate band of £624,000 represents only a small proportion of their assets. With the need to wait for seven years between each transfer to trust, it would take many years to reduce their estates significantly. Any excess over the nil-rate band transferred to trust would be subject to immediate IHT of 20%, and further charges every 10 years and on distributions.

Families and partners

We advise Mr and Mrs Smith to consider a family limited partnership (FLP). This estate planning tool enables gifts to be made down the generations without an immediate IHT charge, while allowing the donor to retain a degree of control and protecting assets for the long term. FLPs have the following features:

• A limited partnership is a business structure governed by contract law.
• It has at least one ‘general partner’ who is responsible for managing the FLP on a day-to-day basis. The general partner has a small capital interest and a small income entitlement. It has unlimited liability in respect of claims against the partnership, but will be a company so that its liability is in fact limited. This company will be owned by a trust, of which Mr and Mrs Smith can be trustees, allowing them to retain a degree of control over the FLP.
• There can be any number of ‘limited partners’ who have limited liability and do not take part in managing the FLP, but have the bulk of the economic interest in the capital and entitlement to income. Limited partners cannot withdraw capital or transfer their interests without the general partner’s consent.
• An FLP must operate as a business with a view to profit but, provided there is active management of the assets, it can be used to hold a wide range of investments such as a traditional portfolio or a property investment company. It cannot be used to hold assets that the partners will use, such as the family home or a holiday home.
• The duration of the FLP is potentially unlimited.

Tax advantages

The main advantage of the structure lies in IHT. Mr Smith’s gift of FLP interests to his family will be treated as a potentially exempt transfer for IHT purposes, meaning it will be out of his estate after seven years.

An FLP is transparent for income tax and capital gains tax purposes so each partner is taxed on the underlying profits according to their share.

Mr Smith wants Jane’s young children to benefit from the FLP. Children can be members of an FLP provided an adult enters into it on their behalf. When they reach 18, the children will have to agree to be members of the FLP. However, it is unlikely that they will refuse because they would have to forgo Mr Smith’s gift entirely.

What would happen if Bob’s marriage to the showgirl sadly came to an end? His interest in the FLP would probably be counted in the assets available to him by the English Courts deciding a settlement. However, the underlying capital is locked into the FLP and so the showgirl might only be able to access a proportion of the income rather than the capital itself.

What if Bill’s businesses are struggling? The first advantage is that Bill cannot withdraw his FLP share without the general partner’s consent, so the capital is protected for the future rather than being invested in the business.

Second, if it seems that Bill is wasting his income on his businesses, the general partner can invest in assets that roll up income so there is no income to distribute (although this will affect the income received by the other limited partners). As a last resort, the FLP deed will provide that bankruptcy disqualifies partners from their interests. Bill could be expelled from the FLP without any entitlement to withdraw his share, keeping the share safe from his creditors.

The devil’s in the detail

If an English or Scottish law FLP is used there are regulatory restrictions because it is a collective investment scheme for financial services purposes. This means that certain activities of the general partner in managing the FLP must be delegated to an operator authorised by the Financial Services Authority (FSA). An FSA-authorised investment manager should also be appointed. A bank or investment manager with which the FLP assets are placed may be able to provide these services.

FLPs are more public than trusts, in that they need to be registered at Companies House, but they do not usually need to file accounts.

Careful thought needs to be put into setting up the FLP as the family members’ entitlements must be fixed at the outset; altering them gives rise to a disposal for capital gains tax.

Although the establishment and ongoing costs of an FLP are fairly expensive, the vehicle provides a solution – one that would not have been attainable through more conventional estate planning techniques – to Mr and Mrs Smith’s problem of how to save significant amounts of IHT while giving them peace of mind that the family’s assets will stay in the family.

Mark Summers is a partner and Lisa-Jane Fawcett a solicitor at Speechly Bircham LLP.

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