Cash in the family business – how much is too much?

We are all acutely aware of the pressures which many family businesses have been under over the course of the last two years since the start of the pandemic. With all of the uncertainty and constantly changing guidance for businesses and employers, it is hardly surprising that many business owners have chosen to hold on to hard-earned profits as a liquidity buffer against the threat of further restrictions and cash flow issues. Couple this with the fact that most of us have had less to spend cash on in terms of leisure, holidays and socialising and again, it’s easy to understand business owners choosing to retain cash within their business rather than take (and be taxed on) their usual level of dividends or bonuses.

Whilst all of this makes perfect sense, business owners should be careful not to fall into the “surplus cash” tax trap when it comes to Inheritance Tax (IHT). The value of an interest or shares in a trading (as opposed to an investment) business will generally qualify for 100% Business Relief for IHT purposes provided that certain conditions, such as a two year ownership period, are satisfied. This is hugely beneficial in passing on the family business to the next generation either during lifetime or on death. What many business owners don’t realise however is that there may be restrictions to the Business Relief available to the extent that the business holds “excepted assets”, the most common being surplus cash.

So what is considered “surplus”? Unhelpfully there is no magic formula, although it has been accepted as a broad rule of thumb that cash reserves of roughly 25% of annual turnover may be permissible. Each case is considered on its own merits, however, with HMRC routinely seeking to examine the accounts and other relevant business documentation at the time of death or the lifetime transfer to consider whether the cash is required for the future use of the business. Whilst most of us would expect that cash retained as a buffer would be seen as legitimately held for future business use, HMRC has confirmed that unless there is evidence that the cash has been earmarked for a specific business purpose, it is likely to be seen as surplus. Specifically, HMRC has stated that “the holding of funds as an ‘excess buffer’ to weather the economic climate is not a sufficient reason” to guard against the restriction on Business Relief.

This need not be an issue long term if the accumulated cash does indeed have an identifiable business use to which it is put, but care should be taken to avoid the build up of cash mountains which may unintentionally taint this valuable tax relief.

If you would like more information or guidance on issues relating to family businesses, please contact Lisa Tait, Private Client Senior Manager and a member of AAB’s dedicated Family Business Team.

Find out more about AAB’s family business team here.