Exit Planning – How To Do It?

Alan Pink considers various tax considerations for those thinking of disposing of their business.

Those observing the state of negotiations between this country and the EU at the time of writing might well feel that the title of this article could apply here, except with the insertion of the word ‘not’! If you want to fare better in the disposal of your business than we seem to be doing as a country in the disposal of our EU membership, proper planning is essential. 

The planning considerations differ to some extent, although there are common themes, depending on whether you plan simply to cease business and wind up; sell the business on the open market to a purchaser; arrange a ‘management buyout’ to current senior employees; or, finally, make a gift of the business, perhaps to the next generation of your family. I’ll be considering various planning points arising from all four of these scenarios.

The tax challenge, of course, generally lies in minimising the capital gains tax (CGT) impact of exiting the business. In principle, CGT applies to any kind of disposal of a capital asset, such as shares in a company or goodwill in a business, which has a higher value at the time of disposal than it cost to acquire. With goodwill, usually the whole value of this asset comprises gain, because very often the goodwill will have been built up from nothing by the current owner.

The big question, in CGT planning, is whether entrepreneurs’ relief will be available on the sale. With entrepreneurs’ relief, the rate of tax is 10% on the first £10 million of gains per person, per lifetime; whereas without entrepreneurs’ relief, the rate of tax would normally be 20%. 

Perhaps the best way to bring out the planning issues is by giving some examples of how to do it (or how not to do it). 

Erasmus has run Cricket Limited for the majority of his working life, and, in later years, has watched the business dwindling slowly due to the way the market has changed, new technology, etc. Over the years he has built up a significant cash pile due to a wish to avoid paying high rates of tax on dividends. 

Acting on a suggestion from friends, he decides to put the cash to better use, and buys a large investment property (a block of flats let to tenants) on 1 April 2018. Because the company’s trade is a mere shadow of its former self, the rents which start pouring in from this property actually exceed the profits of the trade, and consequently Cricket Limited has ceased to be a ‘trading company’, which is one of the requirements for entrepreneurs’ relief on sale or winding up of the company. 

However, there is a three-year period of ‘grace’ between a company ceasing to qualify as a trading company and gains on disposal of its shares qualifying for entrepreneurs’ relief. So, providing Erasmus liquidates the company prior to 1 April 2021, the gain he is treated as making on taking all of the company’s assets from it in liquidation should qualify for the 10% tax rate. 

In the above example, the transition between being a trading company and a company which no longer so qualifies is quite clear-cut, happening on the day when the block of flats is bought. In other cases, though, the transition can be much harder to put one’s finger on, as retained profits are slowly invested in more and more non-trading type assets.

Fredrick is somebody who believes in sharing wealth and motivating staff. Although he owns 75% of the company himself, his wife (who isn’t a director) owns 21%, and his senior manager, Stephen, owns 4%. 

On receiving an offer of £10 million for his shares, he’s disappointed to hear, from his accountant, that neither his wife’s shares nor Stephen’s will qualify for entrepreneurs’ relief. 

In the case of his wife’s 20% shareholding, this won’t qualify because whilst she has more than 5% of the company (one of the criteria), she doesn’t fulfil the other essential criterion which is that of having been an employee or officer of the company for the requisite period. The ‘requisite period’ is currently one year, but the government intends increasing the qualifying period to two years, with effect from April 2019. 

Stephen, of course, fails to qualify because he hasn’t got the necessary minimum 5% shareholding. 

The planning point in circumstances such as in Example 2 is obvious. If there is any chance that your company may be sold or wound up in the foreseeable future, look to see whether the shareholders will meet the entrepreneurs’ relief criteria. What Fredrick needs to do, if he wants his wife’s shareholding to qualify, is appoint her as director or secretary of the company and hope that she will have notched up two years in that position before her shares are eventually sold. Stephen might appreciate an extra 1% of the company as well. 

There has been some commentary in the professional press, also, concerning the new expanded version of the ‘5% rule’, which is proposed to apply from April 2019 for disposals from 29 October 2018. Check that the amended definition of ‘personal company’ is satisfied. 

A management buy-out (MBO) is sometimes the best way of obtaining value from your disposal of the business. The particular version to which we have given the label ‘VIMBO’ (i.e. vendor-initiated MBO) is a highly sophisticated method of arranging a management buyout with maximum tax efficiency. 

In outline, the managers who are to acquire the company set up their own company, which acquires your business in exchange for ‘paper’ (i.e. shares and/or loan notes). Fundamentally, the idea is that the business will be paid for out of its own subsequent profits under the management of the new owners, and the complexity of this situation is in trying to make sure that, when the paper is redeemed over the agreed period, those cash amounts will qualify for entrepreneurs’ relief. So, this is something that the vendor, who is initiating the MBO, needs to have very clearly set out in the agreement.

 

One attractive feature of VIMBO is that the selling shareholder can maintain a lien over the shares until such time as they are paid for. 

Roderick, who has just retired, has two principal sources of income: an investment property, which he acquired recently, which yields rents of £60,000 per annum; and the shares in a trading company which he has built up over the years, which also pays him a £60,000 income, this time in the form of dividends, even though the business is now wholly run by his son Richard. 

Each of these two very different assets, as it happens, has been valued recently by specialists at or around £1 million. 

Apart from the income derived from these two assets, Roderick has a reasonable pension and only needs one lot of £60,000 to live a comfortable retirement.

Conventional wisdom in Example 3 says that Roderick should give the shares in the trading company to Richard. However, consider the merits, instead, of gifting the investment property. 

Under the current rules, shares in a trading company generally qualify for 100% business property relief (BPR) from inheritance tax. So, by retaining these shares, he retains an income in retirement (all the time the company does well) but reduces the taxable value of his estate by £1 million (after the necessary seven-year period) by the gift of the property.