10% tax

What does Entrepreneur’s Relief mean for you as a business shareholder?

It was nice to be quoted in today’s North West BusinessDesk.com (registration required) on why now might be a good time for entrepreneurial business owners to consider selling or exiting their business. I thought it might be useful to expand on this short published article.

You may have heard in the fairly recent Emergency Budget that the 18% flat tax rate on capital gains was increased to 28% for higher rate tax payers with effect from 23 June 2010 – the higher rate tax kicks in where total income, including capital gains, exceeds approx £43,000.

So does this mean that you might suffer tax at 28% on the gain if and when you come to sell your business?

For most hands-on digital entrepreneurs the answer should be “No”. On the sale of your business, you should (subject to the qualifying conditions below) qualify for Entrepreneurs Relief which provides a preferential tax rate of just 10% on capital gains crystallised on lifetime gains up to £5m [Note that this increased to £10m].

Compare this with the current super tax rate of 50% for earned income in excess of £150,000 [45% from 6 April 2013]. The difference between capital gains (as suffered on the sale of a business or shares in a company) as opposed to earned income is absolutely critical!

Further, the June 2010 Emergency Budget made Entrepreneurs’ Relief even better by increasing the lifetime allowance from £2m to £5m (saving a potential additional £540,000 of tax) so it is vitally important that you structure your business to take maximum advantage of this valuable tax break [Note that increased to £10m – even more important….!].

Key qualifying conditions for entrepreneur’s relief to apply to the sale of shares in your company:

  • You must hold at least 5% of the ordinary shares and voting power
  • It must be a trading company (most digital, tech and creative businesses would satisfy this condition)
  • You must be an officer or employee of the company
  • You must hold the shares for a minimum of 12 months prior to sale.

So based on these conditions, 20 employee shareholders could theoretically shelter a gain of £100m taxed at just 10%!

It is vitally important therefore that you consider the following potential opportunities and pitfalls in structuring your company shareholdings and arrangements to secure entrepreneur’s relief:

  • % of shares awarded – you would be seriously peeved off if you were awarded 4% of the shares and voting power if, with a little advance planning, an additional 1% could have saved you approx £800,000 in tax if the business ultimately sold out for c£100m – this is a key issue for founders to consider plus for incentivising key management
  • rights attached to the shares – what if you were awarded 10% of the shares of a class that held no voting rights and then found out years later on exit that you were subject to tax at 28% when your colleagues paid tax at just 10% because they all had voting rights (you didn’t think this minor omission was all that important at the start…)?
  • duration of the shareholding – many tax advantaged share schemes such as HMRC approved Enterprise Management Incentive schemes (EMI) used to be more valuable as, not only do they allow you to pick and choose who will be awarded share options, they also allowed for the lowest capital gains rates of 10% under the old CGT regime in pretty much all cases. Not necessarily now… Most EMI schemes are structured such that the options are exercised at the point of a sale of the company or exit, however, if this pattern of facts unfolds you would not have held the shares for the necessary 12 months. You would fail the test. You would have had to have exercised the share options and acquired the shares 12 months before the deal to qualify for entrepreneur’s relief (this assumes that you had the cash to fund the share acquisition which is often a practical difficulty in itself)
  • role of shareholders – there is no requirement to work a specific minimum number of hours or hold a particular post but to qualify you must formally hold a post within the company, either as an officer or employee. Non-executive directors should qualify so long as they are formally engaged – but what does this mean for many angel investors? Also, consider advance planning if you are a husband and wife company – shares can be transferred between a husband and wife (or civil partnerships) without triggering a taxable capital gain so it is sensible tax planning to consider transferring a minimum of 5% of the shares as soon as possible and ensuring that the recipient spouse carries out some role (with a title) in the business.

The key tipping point for shareholders is on gains exceeding £7.5m as this is the point at which the hike in tax rates from 10% to 28% (as opposed to 18%) but compensated for the increase in lifetime allowance to [£5m] (from £2m) really bites.

Although this is splitting hairs for most entrepreneurs as getting the most out of your business at the end given all the blood, sweat and tears suffered in building it is absolutely paramount. So don’t risk leaving it until you (and your team) are sitting on a capital gain of £8m+ before you start thinking about this stuff. Fancy a coffee?

The above information is for educational and entertainment purposes only and does not constitute professional advice. Please contact me if you would like to discuss factors specific to your circumstances or discuss with your professional adviser.

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