When younger members of a family start a business, they often ask other family members to provide part of the necessary capital. If you are approached to do this and are willing to provide funding, it is often difficult to know how best to provide the cash. The situation is complicated by the fact that what is and what is not agreed is often determined by family dynamics, rather than commercial considerations. There are significantly different effects depending on how the funds are provided. Here are the pros and cons of the most common methods.
A gift of money is (if above the annual allowance) a potentially exempt transfer for Inheritance Tax purposes. It may therefore create a tax liability if you die within seven years of making the gift. Secondly, a gift creates no requirement for the recipient to do anything at all in return and certainly not a requirement to refund the gift at any time. If the business goes bust, there will be no tax relief available for the lost investment. If it succeeds, there will be no income stream arising.
A loan can be provided which carries interest at an agreed rate. If interest is payable, you will normally have to pay tax on the interest received. If the loan is repayable and the repayment terms are not met, you can sue for the money. You may also be able to get security for the loan, by way of guarantee from the borrower or by securing it on some asset or assets. What is important is to make sure that the paperwork recording the terms of the loan is done correctly. Relying on a verbal agreement is very unwise. If the loan is lost, relief for Capital Gains Tax (CGT) purposes is normally available as regards the capital sum. There is no real scope for a capital gain with a loan – your return will normally be limited to your investment plus interest. However, some loans may be convertible into shares, which may prove an attractive option if the business is successful. If the business fails, however, taking action to obtain repayment may prove to be especially unpopular if the debtor is a family member or friend.
If the business is a company, you may be offered shares in the company. This can be attractive if you expect the value of the shares to rise. If the business fails, a loss for CGT purposes normally arises and this can be carried forward to set against future chargeable gains. Also, in some circumstances a loss for Income Tax purposes may be available. For this to be the case, the shares must have been ‘new’ shares issued by the company, not shares bought from an existing shareholder. Other restrictions also apply for Income Tax relief to be granted in such cases.
However, shareholdings, especially minority shareholdings, have significant disadvantages. Firstly, a minority shareholder often has no control over the company nor, in particular, over the dividend stream arising. Secondly, there is no right of repayment and in many cases a minority shareholding may be difficult or impossible to sell. It is always sensible to try to protect a significant investment in the shares of a private company by having a shareholders’ agreement drawn up.