Avoiding an IHT trap when borrowing money for a business

IHT and business interests

Whether an owner is in business as a self-employed individual, in partnership or own shares in a company, business property relief (BPR) can protect their estate from inheritance tax (IHT) if the worst were to happen to them. However, several years ago BPR took an unexpected hit from new rules targeted at tax avoidance.

Debts and assets

Broadly, the rules were introduced to block schemes that reduced IHT using debts, such as loans. At the time, debts which were secured on an asset specifically reduced the value of that asset for IHT purposes.

Example. In July 2010 Sarah owned two homes; one was worth £500,000, against which she had a mortgage of £250,000, while the other was worth £200,000 and was free of debt. In 2010 the value of the properties which would have been taken into account for IHT purposes was £450,000 in total - £500,000 less £250,000 for the first property plus £200,000 for the second. The debt only affected the value of the mortgaged property.

IHT planning with debts

Before the anti-avoidance rule the IHT-efficient way to borrow money was to secure a loan against assets not connected with a business, for example, a home. This meant that its IHT value was reduced by the amount of loan owing while the full value of the business could qualify for BPR. In other words, the loan didn’t affect the amount of BPR the owner was entitled to.

Following the introduction of the anti-avoidance rule, a loan secured on a non-business asset, say a home, which is used to fund a business will reduce the value of the business first instead of the asset it’s secured on - before the application of BPR.

Example. Tim owns 25% of the shares in Acom Ltd. They are worth £800,000. He funds the purchase of his shares in Acom using a loan of £200,000 secured by a mortgage on his home. If Tim were to die or give away his shares, say to his children, the amount of loan outstanding will reduce the value of his shares rather than his home. The shares will still qualify for BPR so that no IHT would arise, but the full value of his home will be chargeable to IHT. This means his estate will pay IHT on an extra £200,000 compared with what would have been chargeable before the anti-avoidance rule.

While the anti-avoidance rule was introduced in 2013, it applies to loans/debts created at any time, i.e. before or after 2013. There’s no way to sidestep the effect of the rule but steps can be taken to mitigate it.

If a business needs funds, the owner should use their savings if they can afford to. Later - the later the better - they could take out a loan to replenish the savings. In the event of their death or if they give away the shares, it can be argued that the loan was not used to fund the business but to buy investments. If the argument is successful it would protect the value of the business for IHT purposes as it would be unaffected by the loan and BPR will be maximised.