The tax cost of improvising in family business successions

One of the main worries facing heirs upon succession to a family business is the tax cost of the transfer. Without prior planning—including a detailed analysis of the applicable legislation and available tax relief— when the time actually comes, there is nothing, or very little, which can be done to reduce the tax bill.

In Spain, the inheritance and gift tax (ISD) has been devolved to the autonomous communities, which have some legislative authority in this area, meaning that the taxation of inheritance and gifts can vary a great deal depending on the actual rules applicable. If, in addition, the situation involves an heir or a deceased who is not resident in Spain, the differences can be even greater despite the recent reform aimed at avoiding discrimination between European Union residents.

For this reason, when planning for succession to a family business, there are two factors to which careful consideration should be given:

• The ISD legislation applicable. A distinction needs to be drawn between two situations: that in which the rules of a particular autonomous community cannot be applied to the taxpayer (for example, where one of the heirs is resident in a non-EU country, the legislation applicable is in all cases that of the Spanish State, which is less advantageous than that of any autonomous community); and that in which the rules of the autonomous community in question can be applied but there exist other autonomous communities with more advantageous legislations (the ISD levied in Spain varies from one autonomous community to another and the differences can be quite considerable).

When designing a Contingency Plan, the objective should be to apply the legislation which is most advantageous, although without any contrivance being involved. It may even be possible to avoid altogether the application of Spanish legislation, e.g. through the relocation of assets currently in Spanish territory, or actual changes of residence, or special testamentary dispositions. A thorough analysis needs to be made of the applicable legislation to avoid running any risk.

• The 95% reduction to the ISD tax base for family businesses. The application of this reduction, which is available for businesses of this kind only, is conditional upon the meeting of certain conditions and requirements—some of which are formal in nature—affecting the family-member shareholders.

• Ownership percentage. This must be 5%, individually considered, or 20% considered overall at family-group level, with both the State and the autonomous community legislations envisaging differing degrees of kinship and scope.

• Actual management. This condition must be met by the deceased him/herself or by some of the members of the family group counted for the purposes of the 20% referred to above.

• Remuneration for directorship functions performed. This must account for 50% or more of total earned income and income from economic activities for the period.

Although these requirements seem, in theory, fairly easy to meet, they in fact need to be strictly monitored and thoroughly checked to ensure that there is no breach of the rules, since this could result in the loss of entitlement to apply the 95% reduction for ISD purposes, generating a serious and very costly problem for the heirs to the business.

Family businesses therefore need to have a prevention plan in place containing provisions to ensure that compliance with all legislative requirements is thoroughly verified, thereby guaranteeing strict compliance with the law and the applicability of the pertinent tax benefits.

This and other questions related to succession to family businesses are discussed in the most recent newsletter issued by our specialists in this area of law.

Garrigues Family Business Department