The new allure of EIS for members of pension schemes
29th November 2024
Posted in Articles by Forbes Dawson
It is now almost old news that from 6 April 2027, pension schemes will be subject to inheritance tax (IHT). After that, beneficiaries will still have to pay income tax on anything further that they withdraw. Pension schemes are therefore no longer the IHT ‘safe haven’ that they were before and previously we have discussed how the effective tax rate for beneficiaries could be up to 91.3%. The challenge for pensioners who anticipate leaving significant pension assets when they die is therefore to pay as little income tax as possible when extracting pension funds. Short of leaving the UK (which we covered last week), Enterprise Investment Scheme (EIS) investments may now look much more attractive to them.
Recap of headline benefits
The key benefits of EIS investments are as follows:
1. 30% of any qualifying investment can be offset against income tax liabilities in either the year of investment or the previous year.
2. Gains made between three years before and one year after the investment can be deferred (and deferred gains will disappear on death).
3. As unquoted shares in a trading company, most EIS shares will qualify for IHT Business Relief on death (once they have been held for two years).
Therefore, this idea involves extracting pension funds and using those funds to make EIS investments.
Example
Nina has a £1.5m pension scheme but does not need to touch it because she is living off capital and income from personal investments (and has withdrawn her tax-free lump sum). The best guess of what will happen to that fund on her death is that the Government will take 40% IHT which comes to £400,000 and then her son, Dave, will pay 45% tax on the remainder, leaving him with £330,000 (things are actually more complicated than this because the nil rate band would be apportioned between the pension and the rest of the estate but I am keeping things simple). Nina has £30,000 of taxable income each year and made a £400,000 gain on the disposal of an investment property last year.
Instead of leaving these assets to erode down to a fraction of their value, Nina has the following plan:
1. Each year she takes £70,000 from her pension to take her income up to £100,000 (this creates marginal income tax of £23,946)
2. She then uses this to make a £70,000 EIS investment (which gives rise to £21,000 income tax relief).
3. She recoups £14,000 on £70,000 of her gain which is deferred.
4. She intends to live for more than two years and so the plan is that her son will inherit the shares free from IHT.
If the shares simply keep their value, then Dave would end up with £70,000 of shares and £8,400 (60% of capital gains tax refunded, net of 40% IHT) in respect of the capital gains tax deferral. I suppose that to be totally accurate, we should also deduct 60% of the net income tax of £2,946 that Nina paid, amounting to £1,768 (i.e. the net funds which would have been taxable in her estate at 40% had she not crystallised the additional income tax liability).
Therefore, Dave ends up with £76,632 of assets after tax compared to £23,100 that he would have ended up with if Nina had let things ride.
Forbes Dawson view
This example makes the lure of EIS schemes very compelling indeed. However, it brushes over one key issue which is risk. Although EIS investments can be hugely successful, they are high risk, and it is quite feasible that all the investment could be lost. This would mean that Dave would end up with just £6,632 of assets in the above example, compared to £23,100 if extracted from the scheme on death. However, if risk can be managed through diversification (or perhaps by investing in EIS funds) then many plucky pensioners will feel that the odds are right for a punt. Some may even club together to set up their own EIS companies (there are a lot of bored ex-CEOs out there!). Perhaps a nice high end art gallery may work here (but care needs to be taken over qualifying activities). EIS rules are complicated and ‘clubs’ of this kind should take care that no couple owns more than 30% of the company – which is one of the many important EIS conditions to be aware of.
