Pre-Exit Tax Planning - A Brief Guide for Business Owners

Research tells us that over 60% of business owners would immediately sell their business if offered the right price, whether or not an actual sale is in contemplation.  But to derive maximum sale value from an exit, planning needs to begin well before even the first discussions with a potential buyer.

Many issues relating to post-exit management, corporate and personal tax, and corporate governance will be relevant to business owners.  This short article tackles just two of those issues: first, how a successful sale can be assisted – and the price achieved maximised – by incentivising the management team; and, secondly, what steps a prudent business owner should take to ensure using the available personal tax reliefs open to him or her to their best advantage.

We know that business owners – and taxpayers in general – are increasingly concerned about reputational and other risks around tax planning.  We share that concern, and the points highlighted in this article simply seek fairly to take advantage of existing tax reliefs open to business owners in the way intended by Parliament.  They are not “aggressive tax avoidance”.

Incentivising Management: EMI Options

One key way of driving up the value of the business so as to achieve the highest possible purchase price is properly incentivising the workforce – especially those who will be key to a successful exit.  Choosing the right incentive package can lead to significant tangible benefits.

Many business owners plan to reward staff on or after an exit event: many members of staff will have worked hard for the business over many years – and particularly so leading up to an exit.  Often, these plans include either: (1) outright gifts to key individuals from the sale proceeds; or (2) giving them shares before the sale so the buyer will pay the consideration.  However, in both of those examples, the tax consequences are horrible: the generous business owner would be subject to tax on that part of the sale proceeds given away, whilst the employees themselves would be subject to income tax on the receipt.

These disadvantages can easily be side-stepped by using Enterprise Management Incentive (EMI) share options. From a tax perspective, the exercise price for EMI options should generally be set at the market value of the shares at the date the
options are granted.  The result is that all gains arising to the option holders on an eventual sale should qualify for the special reduced Entrepreneurs’ Relief rate for Capital Gains Tax (CGT) (currently 10% - see below), provided that at least 12 months have passed between the date of grant and the eventual sale.  Unlike conventional share issues, there is no requirement for EMI shares to represent at least 5% of the share capital of the company (or to carry voting rights) in order to qualify for Entrepreneurs’ Relief.

In addition to the significant net benefits for employees (thus maximising their incentive to work towards a successful exit event), the use of EMI options should also give rise to a corporation tax deduction in the target company. This is because the difference between: (1) the total exercise price for the EMI shares; and (2) their open market value on the date of exercise is available for off-set against the company’s taxable profits, and can even be carried forward to use against future corporation tax liabilities to the extent not used in that year.

Given that this corporation tax saving represents a tangible reduction in costs to the Company for current and/or future accounting period(s), it would normally be recognised as an asset in the completion balance sheet, thereby increasing the purchase price accordingly.

The following example illustrates the position:

• Options have been granted over 1,000 ordinary shares (10%) of the total issued share capital, at an exercise price of £1 per share.
• The company is sold for £60million, with £6million being delivered to option holders.
• Given the nominal exercise, the whole £6million is available as a corporation tax deduction.
• At current corporation tax rates of 19%, this means the deductible is worth £1.14million, which could be added to the purchase price.

EMI options are not available in every case.  For companies which do not qualify for EMI options, other structures may be available which carry some of the benefits of the EMI arrangements, such as “growth shares” or “joint share ownership schemes” (which are both outside the scope of this article).  As with EMI options, the key is always to implement these arrangements as early as possible so as to maximise gains which may qualify for capital gains tax treatment (as opposed to taxation at higher marginal income tax rates).

Pre-Exit Tax Planning for Business Owners

Business owners usually devote years of hard work to building thriving, profitable, business.  That is especially true of the period immediately leading up to an exit, when the competing demands on his or her time can seem never-ending.

In our experience, business owners normally take tax advice from the perspective of the business as an integral part of the sale process.  But lack of time – and, too often, a failure to appreciate the issues well enough in advance – frequently means that they are slow to take appropriate advice on their own personal tax position.  This is a major oversight because in failing to consider their own situation, they may forgo the ability to capitalise on a number of tax reliefs which can substantially reduce the overall tax burden on them and their families.

Entrepreneurs’ Relief

The first principle of tax planning is to deal first with any immediate tax liability.  In the case of a business exit, that means CGT.

CGT is normally charged on the gain in value of assets, including an interest in a business.  The tax is charged on the event of a “disposal”, at a maximum rate (currently) of 28%, but more typically 20%.  However, where a person disposes of an interest in a business, Entrepreneurs’ Relief can reduce the CGT rate to just 10%.  There is no limit to how many times Entrepreneurs’ Relief can be claimed, but there is currently a lifetime cap of £10m, above which gains will be taxed at the usual headline CGT rate.

Typically, to claim Entrepreneurs’ Relief, the business must either be a trading company or the holding company of a trading group (or a similar sole trader or partnership).  Additionally, the owner(s) must, for the whole of the twelve months leading up to the sale:

• hold at least 5% of the ordinary shares in the business (or be a partner); and
• hold at least 5% of the voting rights; and
• be an officer or employee (or be a partner).

These criteria are due to be moderated slightly where a shareholding is reduced below 5% as a result of third party investment, but these new rules are not yet in force and business owners are likely to need specialist advice if they are likely to be relevant.

Statistically, the £10m Entrepreneurs’ Relief band will be sufficient for most UK business owners, as most UK businesses are small- or medium-sized.  But there are, of course, many businesses that enjoy significant growth.  But growth is fickle, and hard to predict in advance.  All business owners should therefore consider personal CGT planning to be an integral part of the sale process.

If the sale value is likely to exceed £10m, then by carefully restructuring the ownership of the business at least 12 months before the exit date (often between spouses and/or other family members) it is possible to maximise the CGT saving so as to ensure that as much as possible of the gain is taxed at the preferential 10% rate.  In the right circumstances, this can often mean that, say, £20m-£30m can have the benefit of the lower tax rate rather than just £10m, immediately reducing the CGT bill by £1m-£2m.

IHT and Estate Planning

The second essential limb of personal tax planning for business owners is to consider the likely long-term consequences of Inheritance Tax (IHT) on the net proceeds of sale, both for them and for their families.

Normally, trading businesses are exempt from IHT by qualifying for Business Property Relief (BPR).  But cash proceeds of sale are immediately vulnerable to IHT, which can cause up to 40% of the proceeds to pass to HMRC and not family members (and/or chosen good causes).  Furthermore, any funds that do pass outright to the next generations may be at risk of threats such as divorce, bankruptcy or financial vulnerability in the future.

We find that business owners frequently plan to use at least part of their windfall on an exit event to benefit their children (and grandchildren, if relevant).  But doing so after the terms of a sale have been agreed means that a valuable opportunity to capitalise on BPR will have been lost.  If a business owner knows in advance of the exit that he or she wishes to benefit future generations by a given amount, it would usually be far better to give away a shareholding worth the relevant value before the exit.  Provided that certain requirements are met, doing so will protect the value given away from IHT.

These advantages can be further maximised by giving shares to the trustees of a family trust in addition to, or instead of, making outright gifts to individual family members.  Trusts have the additional advantage of offering protection against the financial threats referred to above.

In essence, trusts sever ‘legal’ and ‘beneficial’ ownership of an asset – in this case, an interest in the business.  This enables the trustees (the legal owners) to exercise control over how the trust fund is used, whilst ensuring that the beneficiaries derive the financial benefit arising.  Trusts have been used in England for about 700 years and they are tried and tested.  They have endured because they continually prove their usefulness.  Saving tax is only one of a number of factors behind the use of trusts and despite some lurid and ill-informed press commentary suggesting otherwise, English trusts are not an aggressive tax avoidance structure.  They are frequently used by business owners and others for legitimate, normal, tax and estate planning.

Trusts are particularly helpful for business owning families: they can ensure that control of the business remains with the senior generation whilst transferring value down across younger generations.  The trust model can also protect the (sometimes contrary) interests of multiple family members - this can be invaluable where family fall-outs occur, as they sometimes do.  They can also ensure that appropriate provision is made in a tax-efficient way for beneficiaries across many generations.

Particularly careful advice is required to ensure that Entrepreneurs’ Relief planning and IHT planning neatly dove-tail, as the combination of reliefs offers both opportunities and potential pitfalls for business owners.

Wills

Finally, whilst not directly relevant to planning for a business exit itself, business owners should always ensure that their Will adequately deals with their business interest.  Only about a third of UK citizens do, and fewer still have a Will which is up to date and fit for purpose.

Business succession holds unique practical challenges, as well as tax-saving opportunities and pitfalls.  The value of too many businesses has been ruined by the failure of their owners to contemplate what should happen to the business on his or her death.  But when appropriately dealt with in advance, and by putting in place a suitable Will, these issues can almost always be resolved satisfactorily.

General Remarks

Executing an exit from a business is often hard work, and the business owner will be faced with innumerable decisions and strategic considerations.  The pace of a deal is often very fast.  This can mean that there is little time to consider, let alone deal proactively with, the issues summarised in this short article.  The good news is that the solution is easy: plan early, and take specialist advice well in advance.  That done, you will have given yourself the best chance of a successful exit, and of enjoying the maximum possible sale proceeds.

For more information please contact Robert Birchall on +44 (0)20 7427 6659/ robert.birchall@crsblaw.com or James Bradford on +44 (0)207 427 1042/ james.bradford@crsblaw.com.