Farm Inheritance Tax Audits: How to Prepare and What to Expect

Introduction

Inheritance Tax (IHT) on farmland can create significant financial challenges for farming families looking to pass their land and business to the next generation. With IHT charged at 40% on estates exceeding the £325,000 threshold, farmers must plan carefully to ensure their land and assets are protected from excessive taxation. Fortunately, reliefs such as Agricultural Property Relief (APR) and Business Property Relief (BPR) can significantly reduce or eliminate IHT on qualifying farmland and farm businesses up to the new £1m cap per individual and £2m per couple.

However, as farming operations evolve, many landowners are turning to diversification to increase income and financial stability. Traditional farming alone may not provide a sufficient return, leading farmers to explore alternative revenue streams such as:

• Holiday lets and glamping sites

• Farm shops and cafés

• Renewable energy projects (solar panels, wind farms, biomass production)

• Equestrian centres and sporting activities

While these diversification efforts can improve profitability, they also introduce complexities in tax treatment. Not all diversified activities qualify for APR or BPR, meaning farmers risk losing valuable IHT relief if their land or business is not structured correctly. For instance, land used for non-agricultural activities may no longer qualify for APR, and rental income from holiday cottages or commercial leases could be seen as an investment rather than an active business, making it ineligible for BPR. Putting these investment-type activities into different structures will eliminate the risk of losing APR or BPR.

Why Diversification Can Complicate IHT Relief Eligibility

Diversification often blurs the line between agricultural and commercial activities, affecting how farmland and assets are classified for tax purposes. Key challenges include:

1. APR’s strict agricultural use requirement – If farmland is used for activities beyond growing crops or grazing livestock, it may lose APR eligibility. For example, a barn converted into a holiday let is no longer used for agriculture and may be disqualified.

2. BPR’s trading business test – While some diversified activities qualify for BPR, others may be considered passive investments. Landowners must demonstrate active management of diversified ventures to ensure eligibility.

3. Partial relief scenarios – If part of the farm remains in agricultural use but other parts are used for non-agricultural business, IHT relief may be granted only on a portion of the estate, increasing tax exposure.

Hence separating the agricultural parts into one company, the trading businesses into another with investment activities in a different structure. A Family Investment Company (FIC) can then be used to streamline the process of managing these different businesses and maintaining the APR & BPR eligibility on the shares. This reduces the complexity and grey areas of IHT planning.

Understanding Agricultural Property Relief (APR) and Business Property Relief (BPR)

When farmland is passed down through inheritance, it may be subject to Inheritance Tax (IHT) at 40% on estates above £325,000. To prevent the forced sale of farms due to high tax liabilities, the UK tax system provides two key reliefs: Agricultural Property Relief (APR) and Business Property Relief (BPR). These reliefs help reduce or eliminate IHT, but they apply under different conditions and to different types of farm assets.

Definition and Purpose of APR and BPR

Agricultural Property Relief (APR)

APR is designed to reduce or eliminate IHT on agricultural land and buildings. It applies to farmland, farm buildings, and some farmhouses, provided they are used for agricultural purposes at the time of transfer. Relief is available at either 100% or 50%, depending on how the land is owned and used.

To qualify for APR:

• The land must have been used for farming for at least two years (if owner-occupied) or seven years (if rented out).

• Farmhouses must pass the "character-appropriate" test, meaning they must be proportionate in size and function to the farm.

• Non-agricultural land and buildings do not qualify, even if they are part of a farm business.

Business Property Relief (BPR)

BPR provides relief from IHT on assets that are part of a trading business, including farms. Unlike APR, which is limited to agricultural property, BPR covers wider business activities, including diversified farm enterprises such as farm shops, renewable energy projects, and food processing businesses.

To qualify for BPR:

• The farm business must have been actively trading for at least two years.

• More than 50% of the business’s activities must be trading rather than investment-based (e.g., letting land for rental income is considered investment, not trading).

• Relief is available at 100% for businesses and shares in unlisted farming companies or at 50% for land and buildings owned personally but used in the farm business.

Key Differences Between APR and BPR

When Farmers Can Claim Both APR and BPR

In some cases, farmers can claim both APR and BPR, providing maximum IHT relief. This typically happens when:

1. The farm is actively trading – The farmland and agricultural buildings qualify for APR, while the farm business itself qualifies for BPR.

2. Diversified farm businesses exist – If parts of the farm are used for non-agricultural activities, those areas may not qualify for APR but could still be eligible for BPR if they are part of a trading business.

3. Farmhouses fail the APR test – If a farmhouse does not meet APR’s "character-appropriate" test, it may still qualify for BPR if it is used for the active management of the farm.

The farmhouse can also be separated to utilise the Residence Relief (£175,000) and the Nil Rate band of £325,000 separately, giving a couple £1m combined IHT relief on the farmhouse and then £2m combined APR/BPR relief on the Farm and supporting businesses.

A combination of trusts can then be used on farmhouses above this £1m IHT relief & £2m APR/BPR, along with a Family Investment Company to streamline the management of the business parts and personal assets gifted into trusts.

How Diversification Impacts APR Eligibility

Agricultural Property Relief (APR) is a key Inheritance Tax (IHT) relief that applies to farmland and agricultural buildings, but it comes with strict conditions. One of the main requirements is that the land and buildings must be used for active agricultural purposes. As farms increasingly diversify into non-agricultural activities such as holiday lets, farm cafés, and renewable energy projects, they risk losing APR eligibility on parts of their land and buildings. Understanding how diversification affects APR is crucial for tax planning and ensuring maximum relief from IHT.

APR’s Requirement for Active Agricultural Use

To qualify for APR, land and property must be used for genuine agricultural purposes at the time of transfer. HMRC defines agricultural use as:

• Growing crops or rearing livestock for food production.

• Grazing land for agricultural animals, including sheep and cattle.

• Using farm buildings for agricultural operations, such as grain storage or milking parlours.

The key issue with diversification is that APR does not cover commercial or non-agricultural activities. If farmland or buildings are repurposed for a non-farming business, they may lose APR eligibility, even if they are still part of the wider farm.

Why Non-Agricultural Activities May Disqualify Land and Buildings

Many modern farms generate income from non-traditional sources, such as:

1. Holiday lets and glamping sites – If old barns are converted into holiday rentals or campsites are established on farmland, these areas are no longer used for agriculture and may not qualify for APR.

2. Farm cafés, pubs, and shops – A farm café or shop that sells mainly third-party products rather than homegrown produce is considered a commercial business, which is outside APR’s scope.

3. Equestrian businesses – Land used for horse livery, riding schools, or competitions is not considered agricultural unless the horses are actively involved in food production.

4. Renewable energy projects – Solar farms, wind turbines, and biomass production can complicate APR claims. If the energy is used for the farm’s own operations, relief may still apply, but if the land is leased to an energy company, it is more likely to be classed as an investment asset.

Partial APR Claims – How Mixed-Use Farms Are Assessed

Farms that combine agricultural and non-agricultural activities may qualify for partial APR, where only the farming portion of the estate benefits from relief. HMRC will assess:

• How much of the land and buildings are still used for agriculture?

• Whether any non-agricultural activities are secondary to the main farming operation.

If parts of the farm can qualify for Business Property Relief (BPR) instead of APR.

How Diversification Affects BPR Claims

As farm businesses evolve, diversification into non-agricultural activities such as holiday lets, farm shops, and renewable energy projects can provide additional income. However, these activities can also impact Business Property Relief (BPR) eligibility for Inheritance Tax (IHT) purposes. While BPR is designed to protect trading businesses from IHT, farms that generate significant investment income rather than trading income may fail to qualify.

Understanding when diversified income streams can still qualify for BPR, the risks of being classified as an investment business, and how to structure farm businesses properly can help farmers retain IHT relief.

A Family Investment Company (FIC) will mitigate this, as the rental income will be an expense to another business owned by the FIC to cancel out the group of companies looking like a purely investment type business.

When Diversified Income Streams Can Still Qualify for BPR

Unlike Agricultural Property Relief (APR), which only applies to agricultural land and assets, BPR can apply to a wider range of business activities. Farms that have diversified can still qualify for BPR if they meet HMRC’s "trading test."

To qualify for 100% BPR, the farm business must:

• Be a trading business, meaning more than 50% of its activities involve trade rather than investment.

• Have been owned and operated for at least two years before the transfer.

• Be actively managed and run by the owner rather than passively generating rental income.

The Risk of Being Classified as an "Investment Business"

HMRC distinguishes between trading businesses (which qualify for BPR) and investment businesses (which do not). Farms that derive too much income from passive investments—such as land or building rentals—may lose BPR eligibility.

Risk factors that could result in a farm being classified as an investment business include:

• Letting out farmland or buildings for passive rental income.

• If a farm leases land to another business (e.g., for commercial storage or long-term residential lets), HMRC may classify this as an investment, disqualifying it from BPR.

• Holiday lets and glamping sites with limited involvement.

• If the owner simply rents out farm buildings for holiday lets without actively managing the business (e.g., providing services such as catering or guided tours), it may be seen as a passive investment rather than a trading business.

• Leasing land for renewable energy projects.

• If a farmer leases land to a solar or wind energy company, it is considered an investment activity. However, if the farm itself operates the renewable energy project as part of its business, BPR may still apply.

Structuring Farm Businesses to Maintain BPR Eligibility

Farmers who have diversified can take steps to ensure their business retains BPR eligibility:

1. Maintain Trading Activity as the Primary Focus

Ensure that more than 50% of the farm’s overall activities are trading-based, such as selling farm produce, running a farm shop, or managing a hands-on tourism business.

If rental income is significant, find ways to increase trading activity to rebalance the business structure or grow the rental portfolio into a property rental business rather than a few passive income producing properties which would be classified as investments rather than business assets.

2. Actively Manage Diversified Activities

Instead of passively renting out farm assets, ensure that diversified activities are actively managed as part of the business.

For example, a farm offering holiday lets should provide additional services such as catering, guided farm experiences, or equipment hire to demonstrate that it is a trading business rather than an investment.

3. Use Separate Business Structures for Investment Activities

If a farm has both trading and investment activities, it may be beneficial to separate them into different legal entities like a SASS or hold them in a separate trust with the management inside a Family Investment Company (FIC) as another trading business.

Keeping a trading farm business separate from an investment arm (such as property rental) can help preserve BPR eligibility for the trading portion of the business.

Case Studies: Common Diversification Scenarios and IHT Treatment

Farm diversification can significantly impact Inheritance Tax (IHT) relief eligibility, particularly for Agricultural Property Relief (APR) and Business Property Relief (BPR). Below are three common scenarios showing how diversification affects tax treatment and what farmers can do to maximise their relief.

Steps to Protect IHT Relief When Diversifying

Diversification can provide additional income and financial security for farms, but it also carries risks regarding Inheritance Tax (IHT) relief eligibility. To ensure that Agricultural Property Relief (APR) and Business Property Relief (BPR) remain available, farmers must carefully structure their businesses, maintain proper records, and seek professional tax advice before making diversification decisions.

1. Planning Ahead to Ensure Continued APR/BPR Eligibility

APR and BPR apply under strict conditions, and failing to meet these requirements could lead to significant IHT liabilities. Farmers should take a proactive approach by:

Evaluating diversification plans before implementation – Before converting barns into holiday lets or leasing land for commercial use, farmers should assess whether the changes will affect APR or BPR eligibility.

Ensuring the core farm remains agricultural – If the majority of the land continues to be used for traditional farming (e.g., crop production or livestock grazing), it helps protect APR on those areas.

Keeping the business trading rather than investment-focused – Farms should ensure that more than 50% of their overall activities involve active trading, such as selling produce or providing hands-on farm experiences. Rental income from land or buildings should not become the dominant source of revenue.

2. Keeping Detailed Records of Business Activities and Income Sources

Maintaining accurate records is crucial for demonstrating that farm assets and activities qualify for tax relief. Farmers should:

Clearly separate agricultural and non-agricultural activities – APR applies only to assets used for farming, so records should distinguish between agricultural land and diversified business activities.

Track income sources carefully – For BPR purposes, farms should show that trading income (e.g., selling farm produce, running a farm shop) exceeds investment income (e.g., rental payments from commercial tenants).

Document active business management – If a farm offers holiday lets or renewable energy services, records should prove that the farmer is actively managing these businesses rather than passively collecting rent.

3. Seeking Professional Tax Advice Before Making Diversification Decisions

Because tax rules surrounding APR and BPR are complex, farmers should consult specialist agricultural accountants or tax advisors to:

Assess eligibility for APR and BPR – Professionals can review a farm’s structure and operations to ensure it qualifies for maximum tax relief.

Plan business restructuring if necessary – If diversification activities risk losing relief, restructuring the business (e.g., forming a limited company for non-agricultural activities) may help retain BPR.

A Family Investment Company (FIC) can be used to incorporate each part of the farm separately, streamline the management of these multiple companies and then use different types of trusts to mitigate IHT and potentially longer require APR or BPR to pass

on the control of the farm to the next generation if the plan is to become a more passive investment type business in the future.

Ensure compliance with HMRC rules – Proper tax planning can prevent costly mistakes and disputes with HMRC over IHT relief eligibility.