Extracting wealth from an owner-managed company and passing it to younger generations requires balancing two distinct regulatory frameworks: Corporate and Income Taxation on extraction, and Inheritance Tax (IHT) on wealth transfer. Treating these steps as a single transaction or relying on aggressive, scheme-based structures frequently triggers anti-avoidance legislation.
This article sets out legitimate ways UK business owners can extract profits and transfer wealth, reviews relevant IHT exemptions, and details specific areas where HM Revenue & Customs (HMRC) has challenged aggressive tax arrangements. Let us understand Extracting Funds via Grandparent Planning: What Works and What HMRC Is Challenging
What Does “Grandparent Planning” Actually Mean?
“Grandparent planning” describes wealth-structuring strategies designed to skip a generation, moving capital or income directly from business owners or grandparents to grandchildren. Common motivations include funding education, establishing deposit funds for first-time home purchases, or mitigating a potential 40% Inheritance Tax liability on the family estate.
Tax planning across three generations involves two distinct tax events:
- Extraction: Moving value out of a corporate entity (subject to Corporation Tax, Income Tax, or Capital Gains Tax).
- Transfer: Gifting or settling that value for the benefit of children or grandchildren (subject to Inheritance Tax, trust tax rules, and Income Tax settlement provisions).
Start with the Company: What Can Be Extracted and How?
Before money can be gifted to a grandchild, it must be extracted legally and tax-efficiently from the corporate structure.
Dividends
Dividends are one of the main ways shareholders may extract profits from a company, subject to the company’s available post-tax accumulated distributable reserves and relevant tax rules.
- Income Tax: Dividend income exceeding the individual Dividend Allowance (£500 for both the 2025/26 and 2026/27 tax years) is taxed at the shareholder’s marginal rate. For 2026/27, the dividend tax rates are: Basic rate: 10.75%, Higher rate: 35.75%, Additional rate: 39.35%
- IHT Note: Paying a dividend to a shareholder does not reduce an IHT exposure on its own; it simply moves value from the company into the shareholder’s personal estate.
Repayment of Genuine Shareholder/Director Loans
Where a company genuinely owes money to a shareholder or director (for instance, via a documented Director’s Loan Account where capital was previously introduced), repayment of that debt is generally a repayment of an amount already owed by the company rather than a dividend or other income receipt. The precise tax treatment depends on the nature of the balance and how it arose.
Repaying a genuine loan extracts existing value that was already part of the director’s estate. It does not extract newly created company wealth on a tax-advantaged basis.
Capital Distributions
Distributions made in a genuine company winding-up may be treated as capital for Capital Gains Tax (CGT) purposes, and Business Asset Disposal Relief (BADR) may be available where all statutory conditions are satisfied.
However, the Targeted Anti-Avoidance Rule (TAAR) under ITTOIA 2005 sections 396B and 404A can apply to certain winding-up distributions. The rules include conditions relating to the shareholder’s interest in the company, whether the company was a close company, whether the shareholder continues the same or a similar trade or activity within two years, and whether a main purpose of the winding-up was avoiding or reducing Income Tax. All statutory conditions must be satisfied before the TAAR applies to recharacterise distributions as income.
Giving Money to Children and Grandchildren: Key IHT Rules
Once funds are held personally, individuals can use statutory exemptions and transfers to pass wealth to younger generations.
| Exemption / Route | Key Conditions & Statutory Limits | Tax / IHT Implications |
|---|---|---|
| Annual Exemption | Up to £3,000 per donor per tax year. Unused allowance rolls forward one tax year only. | Immediate full exemption from IHT. |
| Small Gifts Exemption | Up to £250 per recipient per tax year. | Immediate full exemption, provided no other gift exemption is used for the same recipient in that tax year. |
| Wedding / Civil Partnership Gifts | £5,000 to a child; £2,500 to a grandchild or great-grandchild; £1,000 to another person. | Immediate full exemption if made on or shortly before the marriage/civil partnership. |
| Normal Expenditure out of Income | Must be regular/habitual, paid out of net income, leaving the donor with enough income to maintain their normal standard of living. | Immediate full exemption from IHT. Requires good contemporaneous records of income, expenditure, and gifts. |
| Potentially Exempt Transfers (PETs) | Outright lifetime gifts to individuals are generally PETs. Transfers to bare trusts can also receive PET treatment because the beneficiary has an absolute entitlement. Other trusts have different IHT treatment. | No IHT is normally payable immediately. Generally outside the donor’s estate for IHT if the donor survives 7 years, subject to detailed rules. |
Normal Expenditure Out of Income
The normal expenditure out of income exemption (Section 21 Inheritance Tax Act 1984) can apply to regular gifts of any amount where all of the statutory conditions are satisfied:
- The gift was made as part of the donor’s normal (regular or pattern of) expenditure.
- The gift was made out of net income (taking one year with another).
- The donor was left with sufficient income to maintain their usual standard of living without drawing on capital.
Having high earnings or excess dividends is not enough on its own. Good contemporaneous records of income, expenditure, and gifts are essential evidence when establishing that the exemption applies. When completing an estate account, HMRC form IHT403 is used to present these details.
Potentially Exempt Transfers and Taper Relief
If the donor dies within seven years, the PET is taken into account when calculating the IHT due on the donor’s chargeable transfers. Whether IHT is actually payable depends on the donor’s cumulative chargeable transfers, available nil-rate band (£325,000), and any applicable exemptions or reliefs.
Where IHT is attributable to a gift made between 3 and 7 years before death, taper relief reduces the tax charge payable on the transfer:
| Years Between Gift and Death | IHT Charged as Percentage of Full 40% Rate | Taper Reduction |
|---|---|---|
| 0 to 3 years | 100% | Nil |
| 3 to 4 years | 80% | 20% |
| 4 to 5 years | 60% | 40% |
| 5 to 6 years | 40% | 60% |
| 6 to 7 years | 20% | 80% |
| 7+ years | 0% | 100% / Exempt |
Key Rule: Taper relief reduces the IHT charge on a taxable gift; it does not reduce the capital value of the gift itself and does not apply where no IHT is attributable to the gift (for example, if the gift is fully covered by the Nil-Rate Band).
What About Bare Trusts?
A bare trust can be used where assets are held by trustees for a beneficiary who has an immediate and absolute entitlement to both the capital and income. For a minor beneficiary, the trustees generally hold legal title until the beneficiary reaches age 18 (age 16 in Scotland) and can take direct legal control of the assets.
- IHT Treatment: A transfer into a bare trust may be treated as a PET because the beneficiary has an absolute entitlement. An available IHT exemption, such as the annual exemption, may reduce the amount treated as a transfer for IHT purposes, subject to relevant conditions. Other types of trust (such as discretionary trusts) follow different IHT rules.
- Income Tax Position: Income arising to a genuine bare trust is generally taxable on the beneficiary (utilising their Personal Allowance and Dividend Allowance).
- The Parental Settlement Rules: Special anti-avoidance rules under Section 629 ITTOIA 2005 apply where a parent provides property for an unmarried minor child (or stepchild). If the income arising from parent-provided settlements exceeds £100 across a tax year, the entire income from that source is treated as the parent’s income for tax purposes. Professional advice is essential when determining whether parents or grandparents are the legal settlors.
Where Family Investment Companies (FICs) Fit into Wealth Planning
A Family Investment Company (FIC) is a standard UK limited company used as a structure for holding family assets, investments, or cash reserves.
How Family Investment Companies (FICs) Function
A Family Investment Company (FIC) is a private company used by a family to hold and manage investments as part of longer-term wealth and succession planning. The exact structure depends on the family’s objectives, funding arrangements and tax position.
- Funding the FIC: Parents or grandparents may provide funds to the FIC through a combination of share capital, shareholder loans or other appropriately structured arrangements. The funding method can affect the family’s control, income and succession position.
- Different Share Classes: An FIC can have different classes of shares with separate rights relating to voting, dividends and capital. These are sometimes referred to as alphabet shares, although using multiple share classes is not essential to an FIC.
- Voting Shares: Parents or grandparents may retain voting rights to maintain control over the company’s governance and investment decisions.
- Non-Voting or Restricted Shares: Shares with limited or no voting rights may be allocated to other family members, including children or grandchildren, depending on the objectives and legal structure.
- Investment and Wealth Growth: The FIC can hold investments such as shares, property or other assets. Where family members hold shares with rights to future capital growth, increases in the value of those interests may benefit them rather than the original funder, subject to the company’s constitution and the terms attached to each share class.
- Control and Succession Planning: The share structure can be designed so that senior family members retain appropriate control while younger generations receive an economic interest. Professional legal and tax advice is important because the inheritance tax, capital gains tax and income tax consequences depend on the specific arrangement.
FIC Tax Reality
Where shares are genuinely transferred to younger family members and the donor retains no beneficial entitlement to them, future growth in those shares may accrue to the younger family members rather than the original shareholder. The IHT treatment depends on the ownership structure, valuation, retained rights, funding arrangements, and the wider circumstances.
Updated 2026 Business Relief Rules
Business Relief (formerly known as Business Property Relief / BPR) is subject to strict statutory tests.
- Investment Exclusion: Businesses whose activities consist wholly or mainly of holding investments (such as rental property portfolios) remain excluded from Business Relief.
- 2026 Relief Allowance: From 6 April 2026, a £2.5 million 100% relief allowance applies to the combined value of qualifying business and agricultural property for an individual, subject to detailed rules including the use of the allowance by qualifying chargeable transfers made in the preceding seven years. Unused allowance from a predeceased spouse or civil partner may increase the available allowance to up to £5 million. Qualifying property above the available 100% relief allowance generally receives relief at 50%, subject to detailed statutory rules and transitional provisions.
HMRC Spotlight: Structures That Require Particular Care
HMRC monitors marketed tax schemes and publishes formal “Spotlight” warnings to advise taxpayers where specific arrangements are considered non-compliant or abusive.
Spotlight 62: Dividend Diversion Schemes for Education Fees
- Target Arrangement: Arrangements where owner-managers of private companies set up share-class and trust structures to fund education fees for minor children.
- How It Operates: A new class of shares is issued and acquired by a grandparent or sibling at significantly below market value, then settled into a trust for minor children. Large dividends are voted on these shares to utilise the children’s personal allowances.
- HMRC View: HMRC states explicitly in Spotlight 62 that these schemes fall within the settlements legislation (S619 ITTOIA 2005 onwards). The income is treated as belonging to the parent-shareholders.
Spotlight 63: Property Business Hybrid Partnerships
- Target Arrangement: Arrangements involving individual landlords, Limited Liability Partnerships (LLPs), and corporate members.
- How It Operates: Landlords transfer beneficial interests in property to an LLP. Profits are allocated on a discretionary basis to a corporate member to bypass mortgage interest restrictions and access lower Corporation Tax rates. Promoters claim the structure reduces IHT and qualifies for Business Relief.
- HMRC View: In Spotlight 63, HMRC confirms these arrangements do not work. HMRC considers that property rental businesses fall within the statutory exclusion for businesses consisting wholly or mainly of making or holding investments.
Spotlight 63A: Hybrid Partnerships and Mortgage Indemnities
- Target Arrangement: Property business arrangements involving hybrid partnerships combined with corporate mortgage indemnities.
- How It Operates: Published on 22 April 2026, Spotlight 63A targets setups where a corporate member enters into indemnities for a landlord’s personal mortgage liabilities. The corporate member claims full finance cost deductions and pays Corporation Tax on redirected profits.
- HMRC View: HMRC’s analysis refers to the mixed-member partnership rules in sections 850C and 850D ITTOIA 2005, income-stream anti-avoidance legislation, the tax treatment of LLPs for CGT purposes (section 59A TCGA 1992), SDLT provisions, and, where relevant, ATED.
Spotlight 69: LLP Liquidations and Capital Gains Tax
- Target Arrangement: Arrangements using LLPs and Members’ Voluntary Liquidations (MVLs) prior to incorporation to avoid CGT.
- How It Operates: Assets are contributed to an LLP that is liquidated shortly after, claiming a tax-free CGT base cost step-up on transfer into a limited company.
- HMRC View: In Spotlight 69, HMRC confirms that for MVLs entered into on or after 30 October 2024, Section 59AA TCGA 1992 treats the member as disposing of the asset immediately before contribution, with gain crystallisation when the LLP disposes of the asset. HMRC also considers the SDLT consequences of these arrangements and whether relevant anti-avoidance provisions, including section 75A FA 2003 and potentially the GAAR, may apply.
Red Flags Checklist
When evaluating wealth extraction or grandparent planning proposals, watch for these compliance warning signs:
- Artificial Share Value: Issuing new share classes to relatives or trusts at nominal value when the underlying economic value is substantial.
- Retained Benefit: Structures where the donor appears to retain a benefit from assets supposedly given away, which require careful consideration under the Gifts with Reservation of Benefit (GWROB) rules.
- Investment Relief Claims: Claiming Business Relief on businesses or property structures that consist wholly or mainly of making or holding investments.
- Tax-Only Purpose: Structures lacking genuine commercial, family, or succession objectives beyond tax reduction.
- Promoter Guarantees: Schemes marketed under non-disclosure conditions or promising “HMRC-approved” tax elimination.
A Practical Framework to Assess Proposed Arrangements
Before implementing any extraction or generation-skipping plan, review this decision framework:
- Identify the Source: Is the asset company cash, an existing shareholder loan balance, or personally held wealth?
- Define the Objective: Is the primary aim immediate income extraction, funding education, or long-term estate planning?
- Confirm the Recipient: Are funds passing to adult children, minor grandchildren, or a trust?
- Evaluate Income and Capital Taxes: Determine the Corporation Tax, Income Tax, and CGT consequences before reviewing IHT.
- Check IHT Allowances & Anti-Avoidance: Review PET status, 7-year survival timelines, settlements legislation, and Gifts with Reservation rules.
- Verify Commercial Substance: Ensure company resolutions, share rights, and trust structures reflect genuine legal ownership and operational reality.
- Document Contemporaneously: Maintain relevant HMRC forms and supporting records, including IHT403 where applicable.
How We Help
At HeirPlan, we work alongside business owners, directors, and families to help clients assess the tax treatment, documentation, and compliance requirements of proposed arrangements.
Our advisers assist with dividend structuring, compliant Family Investment Company governance, trust administration, and generation-skipping estate planning.
Frequently Asked Questions
Can grandparents give money to grandchildren without paying Inheritance Tax?
Yes. Certain gifts can be exempt from IHT if relevant conditions are met, including the £3,000 annual exemption, the £250 small-gifts exemption, and the £2,500 wedding or civil partnership gift exemption for a grandchild or great-grandchild. Larger outright gifts may be Potentially Exempt Transfers (PETs) and can become fully exempt if the donor survives seven years, subject to detailed IHT rules.
What is the seven-year rule for gifts?
The seven-year rule applies to Potentially Exempt Transfers (PETs). If a donor survives 7 years after making an outright gift to an individual or bare trust, the gift is generally outside their estate for IHT purposes, subject to detailed rules such as gifts with reservation of benefit. If the donor dies within 7 years, the gift may become relevant when calculating IHT. Taper relief does not apply simply because three years have passed; it only reduces the IHT charge where tax is actually attributable to the gift.
Can a Family Investment Company (FIC) reduce Inheritance Tax?
An FIC may form part of wider family wealth and succession planning. Where shares are genuinely transferred to younger family members, future growth may accrue to them rather than the original shareholder. However, the IHT consequences depend on ownership structure, valuation, retained rights, funding arrangements, and applicable anti-avoidance rules.
What has HMRC warned about in its Spotlight notices?
HMRC uses Spotlights to warn against tax avoidance schemes. Key warnings include Spotlight 62 (diverting dividends to minor children via trusts for education fees), Spotlights 63 and 63A (hybrid landlord partnerships), and Spotlight 69 (LLP liquidations to avoid CGT).
