Richard Lane, Farrer & CoBalancing the need to pay for retirement and cashing in on their hard work and handing over the reins to the next generation.
The UK economy is at a crossroads. On the one hand, the Chancellor is increasing the pension age for all of us at the same time as annuities are continuing to fall, whilst on the other we have seen over the past six months or so an increase in business confidence and much more corporate activity.
As a result of the above, we have seen a number of family business owners coming to us seeking ideas for ways to pay for their retirement whilst others are looking to cash in on their hard work as they hand over the reins to the next generation.
Whilst it may be possible for some businesses to continue to pay both a salary and dividends to the older generation through their retirement this is not always the case and numerous business owners are having to consider the option of withdrawing capital from their businesses. For many, the thought of taking capital out of the family business is difficult to contemplate – the idea was always to gift the shares to the next generation – but they are having to come to terms with the “new normal” in the context of the current economic situation.
This article addresses the opportunity that exists to take out a significant capital sum from a profitable family business whilst also benefitting from the reduced capital gains tax rate of 10% (as opposed to the top rate of 28%) afforded to many business owners under the Entrepreneurs’ Relief (ER) regime. This can be particularly interesting when viewed against current income tax rates for salary and dividends of up to 45% and 30.6% (effective rate) respectively. We also outline some of the planning that owners must do in order to make the most of ER.
Two initial points to note are that:
- only shareholdings in trading companies can attract ER so, for example, owners of shares in a pure investment company (such as a property holding company) or indeed a company which, very broadly, can attribute more than 20% of its profits to investment rather than trading activity, will not qualify for ER, and
- there is a maximum lifetime amount of £10 million of capital gains per person on which ER is available, a consequence of this latter point being that for larger businesses it is certainly worth considering the possibility of transferring shareholdings across the various family members to ensure that each member’s entitlement is fully utilised. In the case of the older generation, it is important to consider ensuring that husband and wife both hold shares in the company. If going down this route, however, it is crucial that the conditions for ER to apply to any future sale are met by the receiving shareholder.
One point worth noting is that, provided the shareholder has held at least 5% of the ordinary share capital for at least 12 months, it does not matter if they also dispose of shares which they have received in the meantime and which they have therefore held for less than 12 months as all of the shares disposed of should qualify for ER by virtue of having held at least 5% for that 12 month period. In addition, the shareholder needs to be either an employee or an officer of the company (an officer for these purposes is either a director or the Company Secretary) and must have held that role for at least 12 months prior to the disposal.
The method by which the older generation will extract cash from the business will not be by way of a sale to a third party but instead by the company buying back the shares (a buyback).
The rules on buybacks have loosened over the past few years and providing the company has sufficient “distributable profits” then the company can effectively buy the shares and cancel these from the register. Distributable profits in this instance are accumulated profits. As part of the process planning is essential and should be started, as outlined above at least 12 months prior to the event.
It is essential that the funds received by the shareholder in return for the buyback of shares are treated as capital (and taxed as such) and so HMRC will need to be approached to confirm this. The Articles of the company will also need to be checked and amended if necessary in order to permit a buyback of shares.
The buyback and cancellation will remove a significant percentage of the issued share capital so the next generation must have new shares issued to them prior to or at the time of the buyback. Again, provided they have held 5% or more for at least 12 months further transfers of their shares (even those held for less than 12 months) should attract ER. These should be held directly by the individual family members if possible, or if for a minor then a trust arrangement could be considered.
Using the above buyback route can allow retiring family members a significant nest egg with which to invest or buy an annuity whilst leaving the next generation in control of the company.
Points to Note:
- Ensure each family member holds at least 5% of the share capital for at least 12 months
- Ensure each family member is either employed by or an officer of the Company providing actual services to the Company for at least 12 months
- Ensure clearance is sought from HMRC in the event of the buyback route
- Issue new shares to the new generation to ensure that they can benefit from ER on future sale/transfers