June 6, 2011
Entrepreneurs’ relief can offer significant tax savings when exiting a business either completely or partially. However to get the maximum benefit of this relief, it is important to think ahead and plan accordingly. There are a number of qualifying criteria to consider depending on your individual circumstances, and action should be taken as soon as possible to avoid disqualification. In most cases, entrepreneurs wishing to use this relief need to review their position at least a year before a sale to ensure they qualify.
This is the first in a series of articles, each looking in detail at the different aspects of entrepreneurs’ relief and the tax planning strategies that will ensure qualification in the event of a sale. In turn the following topics will be covered:
- Maximising the lifetime value of entrepreneurs’ relief; and
- Treatment of different business structures, including partnerships and sole traders.
- Qualifying as a trading business – especially relevant for property businesses;
- Rules for share types and assets; and
- Incentivising employees to benefit from entrepreneurs’ relief.
How much is entrepreneurs’ relief now worth?
Since 6th April 2011, entrepreneurs selling a business or a business interest have the opportunity to pay just 10% tax on the first £10 million of capital gains. As it is a lifetime relief, provided capital gains do not exceed the £10 million limit for any one business disposal, the remainder can be banked for a future opportunity.
Since it was first introduced entrepreneurs’ relief has become more valuable and following the increase in the capital gains tax rate to 28%, it now represents a maximum £1.8 million tax saving. It is therefore worthwhile to carefully consider the tax implications of a sale well in advance.
How entrepreneurs’ relief works in practice – worked example
The example below highlights the difference this tax relief can make to business owners:
David Jenkins sells the software development company he founded from his kitchen table for £15 million. He is a 40% tax payer and required to pay capital gains tax on £14,989,400 of the proceeds of the sale. This is calculated as £15,000,000 – £10,600 annual CGT exemption to leave £14,989,400 chargeable. Since the transaction completed after 6th April 2011 he can benefit from a 10% tax rate for the first £10 million of the gain because he qualifies for entrepreneurs’ relief (ER).
David’s Tax with ER
David’s Tax without ER
£10m @ 10% = £1,000,000
£14,989,400 @ 28% = £4,197,032
£4,989,400 @ 28% = £1,397,032
Total tax on business sale = £2,397,032
What are the basic qualifying criteria for entrepreneurs’ relief?
- The seller must have owned the qualifying asset – usually either a share in a business or company shares – for at least 12 months before the sale;
- The business must be trading, and any non-trading activity should comprise less than 20% of total business activity;
- If the disposal is of shares, the claimant must have been an officer or employee of the company and own at least 5% of the total shareholding, for the previous 12 months;
- The time limit for making a claim is the first anniversary of the 31st January following the tax year in which a qualifying business disposal is made.
Looking at more detail into the complexities surrounding entrepreneurs’ relief
1. How to maximise the value of entrepreneurs’ relief
The important thing to remember is that it is a lifetime relief so for serial entrepreneurs this could restrict its potential value. However because the £10m limit is per person, tax planning makes it possible for other individuals including family members – spouses, civil partners or children – to utilise their individual entitlements too. Provided they meet the qualifying criteria – where a share disposal is concerned, broadly to have held the shares for at least 12 months before a sale; to own a minimum 5% shareholding; and to be an officer or employee of the company, they should be entitled to the relief. A formal appointment and involvement will be necessary if you wish to make a family member a company director, and advice should be taken to ensure the nominated position will be considered genuine by HMRC.
If you think you may have an opportunity to make multiple business disposals over time, meaning that you will exceed your lifetime allowance, looking at ways in which family members can become involved in the business and use their entitlements can be very shrewd tax planning. If the outright transfer of shares to family members is not desirable, it is possible to use different forms of trusts to hold their shares; the relief will still be available if the nominated beneficiary meets the qualifying criteria. Again, a long term view is needed as the trust must have been in existence for at least a year before the sale for the relief to be available.
2. Treatment for different business structures including partnerships and sole traders
Many business owners will establish their business as a limited company because this has tax planning advantages in sheltering income from the current 50% income tax rate. When they sell their business, they will dispose of their shareholding and so in order to claim entrepreneurs’ relief they must satisfy the 12 month criteria outlined above – i.e. they must be employees or officers of the company and must own at least 5% of the share capital; and the company must be a trading company.
Other business structures can also qualify for entrepreneurs’ relief, but the qualifying criteria are slightly less restrictive:
Partnerships and limited liability partnerships (‘LLP’s)
For tax purposes partnerships and LLPs are transparent, which means that each partner or member is taxed on their share of the income or gains as they arise. On disposal of the business or a share in the business, a capital gain arises which is taxable on each individual partner or member, according to their capital share. Entrepreneurs’ relief can be available provided the individual has been a partner or a member for the previous 12 months, without the requirement for a minimum 5% ownership, or indeed any working involvement in the business. For this reason, a partnership or LLP structure is more flexible for sleeping partners, or for those owning a minority interest, and can provide an attractive way to incentivise employees by offering them participation in the business.
This may be an uncommon structure for a business contemplating a disposal but nevertheless it does qualify for entrepreneurs’ relief. A sale of the whole or part of the business can qualify for relief and there is scope for significant tax planning without involving a business sale by transferring the business into a limited company that is owned by the same business owner. This can be used to extract the current value of the business at a tax rate of 10%. Sole traders (and indeed partners) can also use entrepreneurs’ relief by bringing in new partners.
Sale of business assets
It is also possible for all business owners to claim entrepreneurs’ relief on the sale of business assets within 3 years after the business has ceased trading. This can be particularly useful where the business premises are owned by the business owner but are sold separately to the business. Entrepreneurs’ relief can be claimed for disposal of the business premises, but this requires careful tax planning many years in advance, and also at the time of disposal of the business: it is important for any business owner in this situation to take advice at an early stage.
Part 2 of this article will look in more detail at aspects of entrepreneurs’ relief including how property businesses can qualify; requirements for shares; and how businesses with an EMI scheme can enable employee shareholders to qualify.
If you have immediate questions about entrepreneurs’ relief, please contact Lesley Stalker [email protected].