The 95% inheritance tax relief for family businesses: requirements and risks

One of the most significant tax reliefs in the succession planning of family businesses is the 95% relief provided for in article 20.2.c) of Law 29/1987 on inheritance and gift tax. Applied correctly, it allows a business or a shareholding to be passed to the heirs at a very low tax cost. Its application, however, is conditional on strict compliance with requirements which, if not met, result in the retroactive loss of the relief together with late payment interest and, where appropriate, penalties.

What does the relief consist of?

Article 20.2.c) of the inheritance and gift tax act provides that, on acquisitions on death (inheritances and legacies) of shares in entities or of assets allocated to economic activities, the value of the assets transferred is reduced by 95% for the purpose of calculating the taxable base, provided the statutory requirements are met.

Many autonomous communities have extended this relief or set even higher reduction percentages (some as high as 99%). In the Balearic Islands, regional legislation introduces significant variations from the state rules which must be taken into account in the analysis.

The relief also applies to lifetime gifts subject to certain additional requirements (article 20.6 of the act), although in those cases the conditions are stricter and the relief is generally of a smaller amount under Balearic legislation.

Requirements for the relief

The 95% relief requires two sets of requirements to be met: those relating to the business or entity transferred (the requirements for the wealth tax exemption) and those relating to the acquirers.

Requirement 1: exemption of the shares from wealth tax

The first requirement is that the shares transferred were exempt from wealth tax in the year of the death or gift. The wealth tax exemption for shares in entities (article 4.Eight.Two of the wealth tax act) requires the following conditions to be met simultaneously:

• Genuine economic activity: the entity must carry on a genuine economic activity. Entities whose principal activity is the mere holding of assets (let property or financial assets) are not exempt unless they have significant human and material resources allocated to their management.
• Minimum holding of 5% individually or 20% as a family group: the holder must own at least 5% of the capital individually, or 20% counting the holdings of a spouse, ascendants, descendants or collateral relatives up to the second degree.
• Management functions: the holder or one of the family members in the group must actually perform management functions in the entity and receive for doing so remuneration representing more than 50% of their total employment and business income.

Requirement 2: holding for 10 years

Those acquiring the assets or shares must retain them for the ten years following the death (or gift), without transferring them or reducing the holding in the entity's capital below the threshold that gave rise to the exemption. Failure to meet this requirement results in the loss of the relief, with a supplementary assessment, late payment interest from the date of acquisition and, where appropriate, a tax penalty.

The most common errors that give rise to liabilities

Our practice shows that the errors that most frequently result in the loss of the relief are the following:

1. Asset-holding entities presented as trading entities

Whether an entity is classified as a mere asset-holding entity (and therefore excluded from the exemption) does not depend on its objects clause but on the economic reality of its activity. A company holding several let properties with no employees of its own and no significant management costs may be classified as an asset-holding entity even if its objects clause refers to property management. The tax authorities apply article 4.Eight.Two of the wealth tax act with increasing rigour, and failure to meet the genuine economic activity requirement is the most frequent exposure in inheritance tax audits of family businesses.

2. Management functions not documented

The requirement of remunerated management functions must be capable of being evidenced with sufficient documentation: employment or service contracts, payslips, board minutes, registration of directors at the Commercial Registry and, where there is doubt as to the weight of the remuneration in the holder's overall income, personal income tax returns for the relevant years. A mere reference in the articles of association or in the deed of incorporation is insufficient without evidence of effective performance and significant remuneration.

3. Transfers or dilution during the holding period

The ten-year holding period is a long one. During that time events may occur that inadvertently compromise compliance: capital increases with third parties that dilute the holding, corporate restructurings (mergers, demergers) involving a share exchange, or partial disposals to raise liquidity. Each of these events must be analysed from the perspective of preserving the relief before it is carried out.

4. Lack of advance planning

The 95% relief applies at the moment of acquisition, but the requirements must be met before the death or gift. If the corporate structure does not meet the wealth tax exemption requirements in the year of the transfer (for example, because the entity holds excess assets not allocated to the economic activity), the relief is lost in full. Advance planning to adapt the corporate structure is essential to secure the relief when the time comes.

Conclusion

The 95% inheritance tax relief is one of the most powerful tax incentives in the Spanish system for the transfer of family businesses. Using it can produce very significant savings, sometimes of hundreds of thousands of euros, compared with an unplanned transfer. Incorrect application, or the subsequent loss of the relief, can however give rise to very costly supplementary assessments with interest accumulated over years. Planning ahead, properly documenting the management functions and periodically monitoring compliance with the requirements are the three keys to using this relief with confidence.

At Lex·on we advise on estate planning and the succession of family businesses from Palma de Mallorca and Manacor. If you are preparing the generational handover of your business, we can review compliance with the requirements before they become necessary.

Source: article 20.2.c) and 20.6 of Spanish Law 29/1987, of 18 December, on Inheritance and Gift Tax; article 4.Eight.Two of Spanish Law 19/1991, of 6 June, on Wealth Tax.
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This article is for information purposes only and reflects the regulatory position in force on its publication date. It does not constitute legal or tax advice and does not replace an individualised analysis of each case.