Anti-avoidance rules limit capital gains tax entrepreneurs’ relief for owners of unincorporated businesses when they transfer their business to a company. Despite this it’s still possible to make the transfer tax efficient. How is it done?

Selling your business

Until 4 December 2014 if a sole trader or partner sold their business to a company in which they were a director shareholder (often the only one), any gain they made, including that from the business goodwill, was liable to capital gains tax (CGT), but only at the entrepreneurs’ relief rate of 10% (if the usual conditions for the relief were met). This was a generous tax break.

Tax saving – the old rules

Broadly speaking, goodwill is the value of a business’s future profits. Selling it allows you to access the future profits at a 10% CGT rate. This is far lower than the income tax payable on the profits (up to 45%) if taken, say, as salary.

Example. Bill started an online retail business as a sole trader. In 2013 it was valued at £150,000, of which £130,000 was goodwill. He sold the business to Acom Ltd, of which he was a director and owned all its shares. Acom paid Bill £150,000 by crediting his director’s loan account. Bill’s capital gain was £130,000, i.e. relating entirely to the goodwill. Bill paid CGT of just under £12,000, and he was able to draw £150,000 tax free from his loan account as and when Acom had the cash available.

Trap. Since 4 December 2014 ER doesn’t apply to gains made from goodwill sold to a company in which you own 5% or more of the shares or have other material connections to.

Still some tax advantage

Despite the loss of ER it can still be tax efficient to sell goodwill to your own company. While in December 2014 the maximum CGT rate was 20% and so produced a fair tax saving compared with income tax rates (up to 45%). Plus, further tax saving is possible.

Tip. By using a special election, which defers when a capital gain becomes taxable, and taking less than the full payment for the goodwill, a very low CGT bill can be achieved.

Example. Assuming similar facts as our first example but moving the sale to March 2021, Bill could organise the deal as follows. Instead of receiving £130,000 for the goodwill he takes £35,000 as a credit to his loan account. The rules mean he’s still liable to CGT on the full gain of £130,000, but by using the elections we’ve mentioned, Bill can indefinitely defer the CGT on the gain relating to the goodwill he hasn’t been paid for, i.e. £95,000 (£130,000 – £35,000).

How much tax?

Bill only has to pay CGT on the £35,000. After knocking off his annual exemption, the CGT is a maximum of £4,540. By comparison Bill, who’s a higher rate taxpayer, would pay up to £11,375 (£35,000 x 32.5%) tax on an equivalent amount of dividends.

Tip. If Bill was married he might consider taking his wife into partnership well before he sells his business to Acom. That way the £35,000 gain is shared and two annual exemptions are available against it. This could reduce the CGT bill by more than £2,000.

This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.