One of the challenges of running a family company is deciding how best to reward those family members who are involved with the business. From a tax perspective, dividend income is often preferred to salaried income because dividends, unlike earnings, do not attract National Insurance charges for the employer or the individual.
Existing shareholders may already receive dividends, and it may be desirable to issue or gift shares to other family members in order that they, too, might receive dividend income in future.
The trouble is, if all shareholders hold shares of the same type, then all will be entitled to a dividend of the same amount per share. If the owners want the flexibility to pay dividends of different amounts to different shareholders (for example to minimise the overall income tax impact or recognise the different contribution each individual makes), something else is needed.
In the past dividend waivers were sometimes used to pay dividends in different proportions, but this is often ineffective from a tax mitigation viewpoint because of rules about “settlements” which apply to waivers between spouses and their dependent children.
The good news is, in some circumstances “alphabet shares” can be used to achieve the desired outcome. What are alphabet shares? Basically the term refers to shares of different classes (often termed “A shares”, “B shares” etc), each having different rights with respect to dividends (and possibly with regard to other matters too).
When setting up a new trading company from scratch, alphabet share arrangements can usually be set up from the start with relatively little complication and without fear of challenge from HMRC.
When changing the shares of an existing company, however, care must be taken to prevent HMRC invoking the settlements rules. Also, if shares are issued to family members at less than their market value and “by reason of their employment”, the transaction may need to be reported to HMRC on form 42 and an income tax charge may result.
To prevent problems with the settlements rules, generally any shares that are to be issued or gifted to family members should have full voting and capital rights, since shares that carry the right to a dividend (but no voting rights etc) represent a right to income (rather than anything more substantial). The gift of a right to income to a spouse or dependent child falls within the settlements rules.
If existing shareholders wish other family members to become shareholders, this is often best achieved by reclassifying and gifting some of the existing shares - rather than the company issuing entirely new shares. A gift of shares to family members does not need to be reported to HMRC on form 42 and, assuming the company is a trading company (rather than an investment company), any chargeable gain on the gift can be held over.
Here is an example of how this works in practice. Mr Smith holds 100 ordinary shares in his trading company ABC Ltd. He is married with two adult children. He reclassifies the shares into 80 A shares, 10 B shares, 5 C shares and 5 D shares, each holding the same rights with respect to voting and capital, but with independent rights to dividends.
Mr Smith then gifts the B shares to his wife, and the C and D shares to each daughter. If the market value of the shares exceeds their original cost, there will be a chargeable gain (even though we are talking about a gift here), but the gift to his wife will be exempt from capital gains tax (CGT) under the spousal transfer exemption, and the gains on the gifts to his daughters can be held over provided both parties make a hold over claim within the prescribed timescales.
Dividends can then be voted independently with respect to each class of share. Mr Smith still retains 80% of the issued share capital and 80% of the voting rights, and therefore retains, for all practical purposes, complete control of the company.
There may be important consequences further down the road, however, if and when ABC Limited is sold or liquidated. Unless Mr Smith’s wife or daughters happen to be directors or employees of the company and meet other qualifying criteria, any gain they make on the subsequent disposal of their B/ C/ D shares may not be eligible for Entrepreneur’s Relief, in which case they would pay CGT at rates of up to 20%, rather than, potentially, just 10%.
With four shareholders as opposed to just one, collectively they might benefit from four CGT Annual Exempt Amounts, but the benefit of that would need to be weighed up against any potential loss of Entrepreneur’s Relief.
A company that wishes to adopt alphabet shares will need to ensure its articles of association contain appropriate provisions spelling out the rights attached to each class of share; legal advice is therefore normally required. The wider consequences, particularly in terms of shareholder control, also need to be carefully considered.
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