Growth shares for inheritance tax planning: passing future company value to your children

Are you worried about inheritance tax eating into what you leave your family? One way to deal with it is to give your children a class of shares that only takes the future growth of your company, so that growth never forms part of your estate. Those are growth shares. Here is what they are, how they work in practice and how they fit into inheritance tax planning, particularly for a family investment company.

What are growth shares?

Growth shares are a different class of shares that typically only capture your company's value above a specified threshold. They do not share in the value the company has today. They only benefit from the future growth of the company above a predetermined figure.

Take a simple example. If your company is worth half a million pounds today, you can set that as the threshold. Anything above the half a million pounds is then allocated or distributed to this specific class of shares, which we will call the growth shares. The existing value stays with the ordinary shares, which you keep.

That threshold is usually called the hurdle, and choosing it carefully is the most important decision in the whole structure. Set it too low and you are giving away value that already exists. Set it too high and the growth shares may never receive anything.

Setting the hurdle: the nil-rate band tip

My pro tip is to set your hurdle strategically and keep your nil-rate band allowance in mind. The nil-rate band is the amount of money you can pass on to your children without you, or them, having to pay inheritance tax on it.

So, for example, say you have £200,000 of your nil-rate band left. You might specify that figure as the threshold, so that anything above £200,000 is allocated to the growth shares, which are already owned by your children. The value up to the hurdle can pass within your allowance, and the growth above it never sits in your estate in the first place.

The point is to line the two things up. The hurdle protects the existing value you are entitled to, and the nil-rate band covers the tax on that existing value when it passes. Everything above the line belongs to the next generation already.

How do growth shares work in practice?

Growth shares only receive capital distributions once the hurdle value has been exceeded. In other words, the proceeds have to go above the threshold, and there has to be enough money to pay the other classes of shares first, before the growth shares start to receive anything.

The easiest way to picture it is a liquidation, even if only a theoretical one:

• First, the ordinary shares are paid. The standard shares receive the company's value up to the hurdle.
• Then the growth shares are paid. Whatever value sits above the hurdle goes to the growth shares.

Going back to the earlier example, with a hurdle of half a million pounds: if the company were worth £800,000 on a distribution, the ordinary shares would take the first £500,000 and the growth shares would take the £300,000 above it. If the company were worth £450,000, the ordinary shares would take all of it and the growth shares would receive nothing, because the hurdle has not been cleared.

The company does not actually need to be liquidated and its assets sold off for the growth shares to be recognised as such. It is the theoretical order of distributions, written into the share rights, that matters.

Growth share rights and HMRC scrutiny

That theoretical waterfall is important when HMRC comes to scrutinise the arrangement. HMRC is most interested in the rights attached to the shares, not in whether the company has actually been wound up. The question it asks is whether, on a distribution of capital, the growth shares would have the right to receive the excess above the hurdle or not.

So the drafting of the share rights is what carries the structure, and it needs to be in the company's articles of association rather than in a side letter or an informal understanding. The rights need to say clearly that the growth shares take nothing below the hurdle and everything above it. Get the rights wrong and you do not have growth shares, whatever you call them.

Growth shares for inheritance tax planning

The key point is that growth shares remove your company's future value from your estate. You are not entitled to anything above the specified threshold. That excess economic value is already owned by someone else, typically your children.

Because you are not entitled to it, it is not part of your estate. It is not something your children inherit on your death, and so it is not something on which inheritance tax will be paid. The growth happens in their hands from day one, rather than building up in your hands and being taxed when it passes.

That is a different approach from giving shares away later. By the time you gift existing shares, the value has already accrued to you. With growth shares, the value never accrues to you at all.

Growth shares in a family investment company

This kind of share is particularly important for limited companies that are acting as family investment companies, meaning companies set up to hold a family's investments rather than to trade.

The reason is the difference between a trading company and an investment company. Typically, a trading company can be inherited by the children free of inheritance tax. For an investment company, that is typically not the case. An investment company has fewer inheritance tax advantages, so if you hold your family's investments through a company you need to put other measures in place to minimise the tax. Growth shares can be a great way to go about it.

In practice the structure looks like this. The parents keep the ordinary shares, which carry the current value and usually the control. The children hold the growth shares. As the investments inside the company grow over the years, that growth belongs to the children's shares and stays outside the parents' estate.

There are a few other considerations to keep in mind when implementing a family investment company, which I cover separately in the FIC strategy wealthy families use. Growth shares are one tool within that structure rather than the whole plan, and they work best when the rest of the company is set up with the same aim in mind.

Next steps

If you run a family investment company, or are thinking of setting one up, start by working out what the company is worth today and how much of your nil-rate band you have left. Then speak to a corporate solicitor about creating a growth share class with the right capital rights in the articles of association, and take tax advice on the hurdle before anything is issued.