It’s now 10 years since the government allowed AIM shares to be held in a stocks and shares ISA, opening the door to investors protecting themselves not just from income and capital gains tax, but from inheritance tax too.

That’s because many AIM companies, though not all, are free from inheritance tax (IHT) if held for two years or more, under business property relief rules that are designed to encourage entrepreneurship and investment in small companies. Tax reliefs are not to be sniffed at, but using AIM stocks to mitigate inheritance tax is a strategy that needs to be handled with care, whether it’s used inside or outside an ISA.

WHAT IS AIM?

AIM is the London Stock Exchange’s junior market. It doesn’t have as stringent rules on listing or reporting as the main market, which leaves investors vulnerable to a greater risk that companies can provide misleading statements. It’s notable that one of the most infamous accounting blunders of recent years took place at Patisserie Valerie, which was listed on the AIM market. These events are still thankfully rare, but lower levels of scrutiny and regulation on the AIM market should give investors some pause for thought.

London’s junior market is also home to smaller, early stage companies, which makes them exciting and dangerous in equal measure. The market capitalisation of the average AIM stock is just £27 million, which compared to an average of £233 million amongst the constituents of the FTSE Small Cap Index of small companies listed on the main market.

That said, there are around 200 companies with a market cap of more than £100 million on AIM, roughly the size which would get them into the FTSE Small Cap index if they were on the main market, so it’s possible to put together a portfolio of stocks that are simply small, rather than microscopic.

PERFORMANCE HAS BEEN MIXED

As a whole, the AIM market hasn’t been a consistently good performer either. Looking at the last 10 years, the AIM 100 index of the 100 biggest stocks on the AIM market has returned just 21%, compared to 102% from the FTSE Small Cap index, based on Morningstar data. That means £10,000 invested in the AIM 100 index would now be worth £12,100, compared to £20,200 from the FTSE Small Cap index.

That’s just one snapshot in time, and there are periods over which AIM has performed better, but investors do need to give some thought to whether superior returns elsewhere might offset some or all the inheritance tax benefits of investing in AIM, especially in light of its elevated risk profile.

Like any market there have been some fantastic performers within AIM over the last 10 years. Looking at some of the better-known names on the market, the share price of automotive engineer AB Dynamics (ABDP:AIM) is up 1,570% over the last decade, public opinion and data outfit YouGov (YOU:AIM) has increased by 1,330% and airline and travel operator Jet2 (JET2:AIM) is up 322%, according to SharePad data.

But at the other end of the scale there are companies which have lost investors most, if not all of their money. So, AIM is definitely a market to approach with a line and rod rather than a trawling net. You also need to remain vigilant for companies graduating to the main market, in which case the IHT protection expires unless you switch to another qualifying AIM stock before this happens.

Experienced investors may be willing to take on these tasks themselves, though many will still be tempted to leave this to a professional manager. There are several smaller companies funds which invest in AIM, but these don’t benefit from the IHT relief. That’s because investors must hold AIM stocks directly to qualify.

There are several fund management firms out there who offer AIM portfolios which are professionally managed, with each stock held in the investors own name rather than through a fund. This means they qualify for protection from IHT, though as you might expect this is a much more costly service, often in the region of 2% per annum, with initial charges levied to boot. Investors therefore need to consider the extent to which additional costs are going to eat into their IHT benefits over time.

TAX RELIEF CAN BE TRICKY

The tax relief itself is also somewhat problematic. Partly that’s because the IHT rules say AIM companies qualify provided they don’t mainly deal in shares or land, but HMRC doesn’t provide a definitive list, so there’s always that niggling feeling of doubt. Investors should also consider the potential for the IHT relief to be withdrawn, especially in tough financial times and with a new government potentially waiting in the wings.

Withdrawal of tax protection would leave AIM investors potentially facing a double whammy of losing their IHT protection and seeing their portfolio value sink at the same time. That’s because any such tax move would likely see big withdrawals being made from the AIM market. There’s no suggestion that politicians of any stripe are considering this, but investors should be alive to this possibility, however remote.

Overall then, the ability to hold AIM stocks in an ISA offers investors one way to manage their inheritance tax liability as well as reducing the income and capital gains tax they pay, but you do have to tread carefully as there are plenty of risks and pitfalls.

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