Entrepreneurs’ Relief is one of the most attractive tax benefits available to business owners and founders, offering the lowest capital gains tax rate (ten per cent) on business disposals. However, entrepreneurs must take sensible steps to ensure that they reap the benefit.
1. Think at least a year ahead
The crucial thing to remember is that all the conditions for entrepreneurs’ relief (ER) must be met for a period of at least 12 months ending with the disposal of the business or, if earlier,the cessation of the trade. This means that last minute planning opportunities are few and it is better to try to keep your business “relief-ready” at all times if possible.
2. Make full use of the allowances available
The ER limit of £10m per person (increased from April 6, 2011) is a lifetime limit, so it is important that you not only make full use of the reliefs available now but also allow for maximum use of the limit in the event of future disposals. Giving a spouse, partner or adult child an interest in the business can enable them to receive a future share in the proceeds of sale, using their lifetime limits as well as your own. Every transferee needs to qualify for ER in their own right by meeting the qualifying conditions as to partnership or employment and, crucially for shareholders, more than five per cent ownership for at least one year after transfer and before the eventual sale.
3. Remember that different rules apply to different businesses
The rules are broadly similar but they apply in different ways to:
- Trading company shares;
- Trading partnerships (including LLPs);
- Assets used by a company or partnership but owned personally (associated disposals); and
- Sole trader businesses.
4. Make sure the business qualifies
It is essential that the business must be a trade and the activities must not include any non-trading activities that are substantial. The word “substantial” is not defined by law but HM Revenue & Customs accept that non-trading activities that make up no more than 20 per cent of a company or partnership’s business will not debar a claim for ER.When considering this test a company or partnership is allowed to take account of the value of goodwill but surplus cash can present problems. This test must be passed throughout the year before cessation or sale.
5. Companies beware of surplus cash
Cash that is not required by a company as working capital or earmarked for capital expenditure or future business investment, may risk loss of ER as a substantial non-business asset.If you are building up cash reserves for a major purpose keep records of meetings and research done into possible acquisitions to prove that the money is retained for business purposes. If you are concerned about surplus cash consider extraction, for example by way of pension contribution or dividend payment well in advance so that the company has a chance of making sure the year before cessation or sale is “clean”.
6. Does your property business qualify as an furnished holiday letting business?
The one exception to the trading requirement applies to furnished holiday letting (FHL) businesses. The rules changed on April 6, 2011 but furnished holiday lettings will continue to qualify for ER. The big change for FHLs, affecting ER, will come in on 6 April 2012: to qualify the property will then have to be let for 105 days per annum and be available for letting for 210 days (increased from 70 days and 140 days respectively). Where properties no longer qualify as FHLs there may be a cessation of business for CGT purposes: no CGT becomes due until assets are disposed of but ER will only be available on disposals within three years after the business ceases to be treated as FHL, so owners need to review their lettings before then to decide what action is needed.
7. Make sure shares qualify for relief
ER is only available on shares and securities in a company if you hold shares that entitle you to more than five per cent of both the voting rights and the company’s ordinary share capital: once the five per cent test is passed other shares such as preference shares and certain types of loan note (non-qualifying corporate bonds) can also qualify for ER.
8. Some five per cent is only a minimum requirement for shares.
If you already hold more than five per cent of the shares in a company and meet all the remaining qualifying requirements you can acquire more shares just before the sale and benefit from ER on the full amount. You do not need to own the additional shares for the complete year before the sale. This is particularly useful if, for example, your spouse does not meet the minimum five per cent test: they can simply transfer sufficient shares to you before the sale to use your ER allowance.
9. Remain an officer or employee for 12 complete months
If you own shares in a qualifying trading company it is important that you remain an employee or an officer until the date the shares are sold, otherwise you immediately lose qualification for ER. Therefore, if you are contemplating withdrawing from a business you should not resign before the contract for sale of your shares has become unconditional. Similarly, a non-employee shareholder (e.g. a spouse who owns shares but is not an employee) who meets the five per cent test can be brought into the ER fold by making them an employee or office holder. There is no minimum working time condition, so long as the employment or office (such as company secretary) genuinely exists.
10. Partnerships do not have minimum share requirements
An individual partner does not have to be active in the partnership at all to qualify for ER, membership is enough but take care that the members’ agreement makes proper provision for division of capital in the event of a sale or other division of capital. Capital is divided in the same proportions as income unless the agreement dictates otherwise but once a person is a partner their share can be increased at any time and all will normally qualify for ER.
11. Sole traders: decide how you want to dispose of the business
A sole trader can only claim ER on selling all or part of a business. This includes sales of the assets used in the business up to three years after cessation. The allowance of claims for sale of part of a business is especially important because it allows a business owner to bring in a partner or transfer a share in the business to a company for cash or shares. So long as you pay the tax on the disposal you can qualify for ER.
12. Beware of past non-business asset use
If an asset is used in your company or partnership’s now but has not always been, the ER on an “associated disposal” may be restricted. This can be the case if the past use was not for business at all or even for a different business. The relief is also restricted if, after April 5, 2008, the asset was rented to the business: sensible income extraction can compromise capital gains tax saving. A possible way round this is to transfer the asset into the business so that it appears on the company or partnership’s balance sheet. This is one item of planning that can be done near to the last minute but it must be completed completely and in time and it brings other costs with it such as legal fees and, for land and buildings, stamp duty land tax.
13. Remember: on a £10m gain, ER can now be worth £1.8m
This has just been a taster of some of the main factors that any business owner needs to be aware of,especially one who is actively thinking of selling in the foreseeable future. The detailed rules governing ER are complex and always need full and careful consideration but time spent planning now can save substantial amounts later.
Chris Williams is a senior manager at Baker Tilly.
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