Passing on the family business tax efficiently

Passing on the family business tax efficiently

Imagine this scenario. Mother and father have been running their business as a company for many years. Some of the children are taking more responsibility in the business and it is time perhaps for the parents to let the children take control. The parents would like the profits which may have been accumulated in the company to be paid out to them if it can be done tax efficiently.

Both these objectives can be achieved by using tax legislation which gives favourable tax treatment to an individual when a company purchases some of its own shares.

In broad terms the steps are:

  • The next generation is given some shares in the company. This may be a minority holding say 30% of the company and may be done several years before the parents want to relinquish control. No tax charge should arise for the parents or the children due to the availability of tax reliefs where it qualifies as a trading company.
  • Sometime later, when parents want to retire, the company buys back their shares. If done correctly the proceeds received by the parents will be taxed as capital receipts for the sale of their shares (rather than subject to income tax). Entrepreneurs' Relief may be available where both the individual and the company meet certain conditions so the tax charge is only 10% on the receipts less the original cost of the shares.
  • Under company law, the company will cancel the shares with the effect that the shares held by the next generation are the only shares in issue. This means they now own 100% of the company.

Are there any problems? Yes there are but we are here to help manage the process.

Playing by the rules

There are rules in company law which must be dealt with. If the rules are not followed, the effect can be that the purchase of shares is an invalid purchase and unfortunate consequences may follow.

There are also tax rules to follow. The two keys matters to establish are:

  • that the company is a trading company for the purposes of Entrepreneurs' Relief. This enables the proceeds from the sale of shares to the company to qualify for a 10% tax rate.
  • that the purchase of shares is for 'bona fide commercial reasons'. A clearance procedure is available upon application to HMRC.

And finally there are financing issues. What if the company has insufficient cash to pay for the shares in one go? This can trigger all sorts of problems for the unwary but it is possible in many cases to resolve the issues.

A recent dispute between an individual and HMRC has recently ended up before a tax tribunal. One of the two shareholders wanted to exit the company as there was disagreement as to the running of the company. £120,000 was paid by the company for the purchase of his shares. The individual expected a capital gains tax bill at 10%. HMRC assessed him to income tax as the shareholder had only owned the shares for four years (one of the conditions for capital treatment is that the shares are owned for at least five years).

He was able to remove the income tax bill at the tax tribunal on the basis that the distribution was unlawful as the company had not complied with a number of company law requirements. The tax tribunal agreed that the £120,000 was not a valid distribution. However, this did mean that the £120,000 paid to him had to be returned to the company. The consequential effect is that the company is instead treated as having lent him the money which triggers off other tax consequences for the company (and him).

And he has to pay the costs of his professional advisers and other costs...

Oh dear. Do please talk to us so that we can guide you through the minefield to a safe 10% tax bill.

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