Family Businesses Cannot Pay Inheritance Tax

Although the farmers’ tax problems have got most of the attention (including from me), the threat to family businesses from the Budget’s inheritance tax expansion goes much wider.

Thousands of non-farming family businesses, employing millions of people, will be facing levels of tax that they simply cannot afford to pay, and will have no alternative but to break up or sell their businesses, at a huge cost to the economy and their local communities.

This is because inheritance tax will be charged on the value of the assets of the business, with no regard to its profits. Therefore when the older generation dies, the inheritance tax bill can easily be too high for the business to produce enough profits to ever pay it off. Yes, farmers will be one of the worst affected sectors, because of the combination of high land prices and low profits from agriculture, but they will certainly not be the only ones.

From next year, when the owner of a family business dies, the younger generations will face a 20% inheritance tax on the full value of the business above £1 million (and, with property values and machinery costs as they are, £1 million doesn’t get you much of a viable, productive business these days). In fact the tax will probably be more than 20%, because HMRC are always keen to identify bits of the business that do not qualify, to charge the top 40% rate on them.

But where will the money come from to pay the tax? Businesses do not keep 20% of their assets in cash; they need to reinvest their money to maintain and grow their operations. Nor do families with businesses generally have that sort of cash – anything they have is usually ploughed back into the business. But without the money to pay an inheritance tax bill, most of them will have to either sell up, sell assets (damaging the business) or take on crippling levels of debt.

It seems the government may allow business families to spread their inheritance tax bill over ten years, which they currently do for some other assets. But they charge interest to do so, currently at 7.25% p.a. (and it's averaged over 8.5% over the last ten years), so anyone spreading their payments will have to fund the interest as well as the tax.

Paying the tax and the interest over ten years will mean the family having to find about 2.9% of the value of the business’s assets every year, for ten years every generation. Trying to spread the payments over a longer period would need a bank loan, probably with an even higher interest rate and crippling their ability to raise finance for new investment.

But while 2.9% might seem tough but manageable, the true cost will actually be more than that, because HMRC treats inheritance tax as a personal liability, not a business expense, so it has to be paid out of after-tax income. That means, depending on the precise level of profits and how it is structured, the business will have to generate profits of between 5% and 6.3% of its asset value before tax, every year, just to generate enough money for the family to pay the inheritance tax instalments.

(Note that’s just using normal tax rates. Some of the odd quirks in the British tax system, such as the loss of the personal allowance, the Scottish rates, or the clawback of child benefit, could push those figures even higher for particular families).

That is just not feasible for most businesses. The average British manufacturing business makes profits (before paying interest and tax) equivalent to just 7.3% of its assets. (1) That means, for the average business, paying a 20% inheritance tax bill would swallow up well over two thirds of the profits each year. Worse, that’s based on profitability in the first half of 2024, before the employer’s NI rise takes a further chunk out of their profits.

And that’s the average, so roughly half of businesses will make less than that, with some business sectors being particularly hard hit. For those businesses with profitability below 6.3% - not far below the average - there simply might not be enough money to ever pay off the inheritance tax at all. 

For those businesses that cannot make enough profits to pay off a 20% inheritance tax bill, the family will have to sell the business, or cripple it by selling off assets, just to pay the tax. And even those that could just about manage to pay the tax are at risk of being sold; when even an average manufacturing business is likely to be left with a return on its investment of less than ½%, after paying its normal profits taxes and the inheritance tax, is it worth carrying on for such a small reward?

Even if they do struggle on, that doesn’t leave enough profit to reinvest in growing or modernising the business; family businesses will, at best, be slowly dying.

One business that has spoken out about this is Manchester’s oldest brewer, JW Lees (as a Mancunian by birth I have fond memories of their Brown Ale). This is a 200 year old, 7th generation family business that employs over 1,500 people; a successful operation. But they say they will “simply not have the cash” to pay an inheritance tax bill and will have to sell, meaning the older generation will “never be able to hand on the … business to our children”.

Sadly that prediction is probably correct; JW Lees’ accounts show them making a pre-tax profit of 3.7% of their net assets, far below the 5-6% return that will be needed to pay off an inheritance tax bill, even if the government does allow it to be spread over ten years.

Regional brewers are one of the business types that will face particular problems; the brewing is supported by them owning a small chain of pubs, a sector that currently struggles to make profits, but which HMRC will put a high value on for inheritance tax because of the potential to close them down and convert them into expensive housing. Such businesses will find it impossible to make enough profits to pay an inheritance tax bill.

But although brewers, like farmers, might be another extreme example, remember even the average business will barely be able to make enough profits to pay a 20% inheritance tax bill. This is a problem that will hit businesses across all sectors.

Based on the government’s figures, roughly 15,000 to 20,000 businesses will have to pay inheritance tax (their statistics say that 552 businesses claimed the old Business Property Relief on assets of more than £1 million in the 2022 tax year, which would mean roughly that many a generation). And that figure will increase as property values grow.

As with the farmers, there is an argument over how many family businesses might be affected, and we have the odd situation of Cabinet Ministers suggesting businesses adopt tax avoidance techniques to shelter more than £1 million from the tax. However tax planning is more complicated than they suggest, there are all sorts of traps that the ill-advised can fall into, and it comes at a cost - not just professional and legal fees but also changed plans, awkward split ownership structures, and the time and effort to plan, implement and operate complex arrangements.

Moreover, as I wrote about in relation to the farmers, when a business is handed on while the older generation are still alive, no inheritance tax is due so long as they survive for another seven years afterwards. Those businesses do not show up in the government’s BPR statistics, but those families will, in future, face seven years of risk.

As I said of the farmers, what does that younger generation do, having been given the family business? Worry for 7 years, knowing that everything they are working for may be taken away to pay a tax bill? Take out expensive life insurance that the business cannot afford? Cut back on essential investment to stockpile cash to cover the potential tax? 

Even if those families still don’t have to pay any inheritance tax under the new rules, dealing with that seven years of risk means they are still hugely affected by it, and a death at the wrong time could, thanks to the Budget, flip them into a tax bill that could lose them their livelihood.

The net result is that all but the smallest businesses are likely to be affected by this tax expansion. And this matters, not just to family business owners but to us all.

More than five in six British businesses are family-owned, and between them they provide the majority of all private sector jobs. Although many of them are very small, the ones who will now be affected by inheritance tax are not. Whilst the proposed £1 million threshold for inheritance tax will exempt the micro businesses that employ few or no people outside the family, a 20% capital tax above that will hit precisely those medium and larger family businesses that provide the bulk of employment.

Even if the government were right that only 20,000 businesses will be affected, there are only around 20,000 medium and large family businesses in the UK, and between them they generate over a quarter of all private sector jobs. 

Looking at the wider aspects, family businesses are often deeply embedded in their local area, with 74% contributing to the community in ways above and beyond their economic impact. If family businesses are sold and bought out by multinationals, those ties to the local community will weaken. We have all seen family businesses bought by bigger organisations, only for local operations to be shut down and transferred to existing facilities elsewhere.

Whilst there is of course an important and beneficial role for large companies, a vibrant economy and society benefit from a diversity of businesses. Most family businesses do not make enough profits to sensibly pay a 20% tax on their capital asset values, most will be forced to sell to fund death duties, and this will be hugely damaging to employment, the economy, business diversity and local communities.

Since the £1 million threshold means the inheritance tax charge is most likely to hit those businesses at the larger end, the ones damaged by this tax are going to be precisely those that provide the most employment and have the greatest impact on their communities. Lose them, and you damage the economy and destroy a lot of opportunity and community cohesion.

(1) The higher profitability of services businesses pushes the overall average up slightly, to 8.8%, but that is mostly driven by professional services (lawyers, accountants and suchlike), which tend not to be inherited – see www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/bulletins/profitabilityofukcompanies/apriltojune2024

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Richard Teather is a chartered accountant who, along with twenty years’ academic experience in tax law and policy, has advised businesses, business organisations and governments around the world.

The opinions expressed here are his own and do not necessarily represent those of any firm or organisation with which he is connected.

This blog post concerns the possible effects of tax reform and policy; it is not and should not be regarded as advice. Tax planning is highly complex and carries many risks, so should not be undertaken without specific, personalised advice.