If you run your own company and plan to retire, the usual strategy is to sell or wind it up and take the money. However, changes to the tax rules in 2016 might make it more tax efficient to keep the company going. Why?
Higher exit taxes
We have already explained the government’s plan to increase tax when you wind up or sell a company and take the accumulated profit ( yr.16, iss.7, pg.1 ). Broadly, the effect will be to increase tax by treating it as income instead of capital. Therefore, if you want to keep the tax bill down you’ll need a different strategy.
If you sell
You stand more chance of escaping the new rules if you sell your company to someone not connected to you, rather than wind it up.
Example. John runs a consultancy firm, Halls Ltd, in which he owns all the shares (which cost him just £1). Halls has accumulated profits of £600,000 largely held in cash at the bank. John retires and sells Halls to a rival firm for £611,000. After deducting his CGT annual exemption of £11,000, John pays CGT on the rest of the capital gain he makes. Because Halls was a trading company the entrepreneurs’ relief (ER) tax rate applies (10%), meaning John will pay CGT of £60,000.
Trap. Despite the sale of Halls being at arm’s length, the new rules may (we don’t know for sure yet as the rules are still being considered) cause some or all of the £611,000 to be taxed as income at dividend tax rates of up to 38.1%.
If you don’t sell
In practice, the type of business John had, i.e. one where he’s the only person who generated income for the company, would be difficult to sell. So he could instead wind up the company and take accumulated profits. Under current rules whatever he took would be taxed as capital and ER would apply. However, the new rules will almost certainly apply income tax to profits accumulated in cash. So whether he sells or winds up Halls John faces tax nearer to £200,000 rather then £60,000.
Tip. Instead of winding up Halls and taking all the accumulated profits at once John could keep it running and withdraw the income over time as dividends. This would be especially tax efficient if he deferred taking his other retirement income, i.e. his pension.
Example. Assuming John has investment income (which he can’t defer) of £5,000 per year, he could top this up with dividends from Halls of say £37,000, which would keep them within the 7.5% tax band. From April 2016 the tax on the dividends would be about £2,700 per year. After 15 years all the cash in Halls would be used at a tax cost of roughly £40,000 (15 x £2,700).
Tip. If John was married he could give his spouse shares meaning that they would also receive dividends. That might allow them to extract all the accumulated profit in half the time at no extra tax cost.
Limited lifespan. The new rules may sink our scheme as the government might include a clause to tax company profits on the shareholders as it arises. However, it’s unlikely to apply to profits accumulated at the time the rules come into effect. Our scheme therefore has a useful, but possibly limited, lifespan.
Keeping the company going means you can draw the money over a number of years as dividends. If at the same time you defer taking your retirement savings (pension), you can draw enough dividends to keep them in the 7.5% tax band. That’s even less than the lowest possible CGT rate of 10%.