Introduction
The Autumn Budget and Finance Bill of 2024 introduced a cap on Agricultural & Business Property Relief at £1m per person, with private property relief of £175,000 and the Inheritance Tax (IHT) Nil Rate Band of £325,000 frozen until 2030.
With the inclusion of pensions into the IHT calculation as well, a couple with a private property and assets over a £1m and/or £2m worth of Farming & Business Assets (£3m combined) will pass on a 20-40% IHT liability to their children.
One of many techniques to reduce or remain below these thresholds is an estate freeze.
What is an estate freeze?
An estate freeze is a process where you buy fixed value bonds, shares and other assets that do not go up in value, as the future value is gifted to the next generation. A loan trust is an example of this used in America but the basic principles are the same, you freeze the value of your net worth for estate, inheritance and tax planning purposes.
Many successful families have used this technique, in one form or another, since the inception of inheritance and wealth taxes in many countries over the years.
More advanced techniques allow for succession planning and therefore allow you to remain in control of your wealth without the tax liabilities.
“Control everything, own nothing” – John D. Rockefeller
What are freezer shares?
One technique in an estate freeze is the use of redeemable preference shares, which are fixed value capital shares, as the shares can be bought back by the issuer for a fixed or ‘frozen’ value. Hence they are called freezer shares.
These freezer shares can come with an annual coupon like a bond but then you are better off buying a bond, as a bond has higher legal charge on income and capital in bankruptcy than shares. Also, a company is better off issuing a bond due to the bond interest being a corporate tax deduction.
Freezer shares are not widely used, due to them being a poor investment unless they are sold at a deep discount.
What are growth shares?
The other half of an estate freeze is to pass on the future growth of the company to a different class of share. They start off with a nominal value of say £1, then as the company grows in value these shares increase in line with the capital gain.
These shares can come with voting rights but usually don’t, as they are used mainly to incentivise employees to work efficiently to grow the company value rather than look to increase their salary and therefore cost to the company.
Start-up companies have used them to pay early employees instead of salaries to reduce their overheads until the first round of funding comes in from investors.
How to use freezer shares and growth shares
The freezer shares can be bought with cash or exchanged for assets like bonds, gold, other shares and even property used in a business. This is called a non-monetary exchange and is how companies are merged and restructured. This is a way financial institutions swap/exchange illiquid assets and accept liquid commodities/crypto instead of a cash investment.
A benefit of using a non-monetary exchange is the built-up capital gain on the business assets/shares can be rolled into the freezer shares, in the UK this is called incorporation relief for business assets or rollover relief for shares and investments.
These assets that capitalise the company, grow in value over time but the investor received a fixed value share/bond, so there needs to be somewhere for the capital growth to be harnessed. That is where growth shares come in. Any future growth over the fixed value of the freezer shares is captured in the growth shares.
The example shows investment like a commercial property that grows 4% in value and makes 5% dividend after costs and taxes.
The £1m Freezer Shares stay at £1m but the Growth Shares end up being worth circa £0.5m with circa £0.6m paid out in dividends to the shareholders.
An example of using freezer shares and growth shares?
An example of the use of freezer shares and growth shares is a growth fund like a hedge fund with 80:20 split. The freezer shares are like the high-water mark, the growth shares are then split 80% to the investor (freezer shareholders) with the hedge fund management team holding the other 20% growth shares.
Each 3 year cycle the gains in the growth shares can be converted into freezer shares and new 80:20 split reset for the next cycle of capital gains to repeat the process. When the fund drops below the freezer shares by 20% and the fund management team believe it will take too long to get back above the higher water mark of the freezer shares, the fund is liquidated. Freezer shares are then repaid at the discounted rate and the company dissolved.
How does a family investment company use freezer shares and growth shares?
A family investment company (FIC) uses a similar principle where the older generation that capitalise the FIC get freezer shares, and the next generation are like the fund managers but with a 20:80 split in their favour. The freezer shareholder in effect receives 20% of the future profits in one way or form by drawing down / redeeming the initial capital in the freezer shares, which reduces their estate.
Also, a combination of dividends into a trust and act as a reserve if they live longer than expected. This trust will be outside their estate to reduce their potential IHT liability, to still work within the estate freeze principles. There are multiple different types of trusts available depending on the circumstances, some more tax efficient than others.
What is the difference between an investment fund and a family investment company?
The difference between a fund and a family investment company is who is in control.
In a fund the investors are passive and can only control what and when they invest their capital into the fund and how they take out their investment maybe controlled by the terms of the fund management.
With a family investment company, due to the alphabet shares, the founders who puts in the capital remains in 100% control over time and can also step away from the day to day and eventually pass on the FIC along with its capital to the others. This is usually the next generation of family members via a controlled succession plan.
What are family investment company alphabet shares?
Alphabet shares are classes of shares with different rights. The main three types of rights a share can have:
Voting = Control
Capital = Built up value of the company
Dividend = Income distribution
A family investment company separates these voting shares away from the capital and dividend shares to allow the founders to freeze the value of their estate but still remain in control. This allows for the founders to retain an income from their capital until they die but also strategically gift the majority of their estate to the next generation to create a sustainable legacy via estate and succession planning.
Why use a family investment company with freezer shares, growth shares and alphabet shares?
The freezer shares, growth shares and alphabet shares in a family investment company allow a family to access the many advantages of an estate freeze, inheritance, estate and succession planning without the loss of control usually associated with the use of discretionary trusts when used on their own.
