Exiting a limited company with Entrepreneurs’ Relief to save tax

When exiting a limited company, entrepreneurs need to extract retained profit from their company. Normally, profit taken from a company would be treated as dividends, and incur the corresponding income tax liability. However, a much-preferred option as we’ll see is to qualify for entrepreneurs’ relief and to treat profit as capital gains. This allows entrepreneurs take advantage of the lower Capital Gains Tax (CGT) rate of 10%, and also the CGT tax free allowance.

If you are a contractor returning to permanent employment due to the IR35 rule change, a property owner closing your property company (more qualifying details are discussed in another article), or a director who simply wants to cash in and move on to the next venture, this article will give you the detail you need to claim Entrepreneurs’ Relief (ER). (“Entrepreneur” is a broad term. this article will focus on directors of personal companies in professional services and properties.)

 

How it works

 

When you close your company, you will probably try to use up your basic rate tax band at 7.5% first by distributing a certain amount of profit as dividend.  After that ER allows you to claim the remaining profit as capital gains and pay 10% tax on this amount (after deduction of CGT annual allowance). This is calculated on your individual Self-Assessment tax return. If you don’t claim ER, all the retained profit will be taken out as dividend, and for the portion subject to the higher rate of 32.5%, will cost much more in tax. The table below illustrates the difference that claiming ER makes to tax.

 

ER Claimed

No ER Claimed

Retained profit of the company

£80,000

£80,000

Taken as dividend – A

Subject to minimum rate personal tax band

£39,500

£39,500

Taken as dividend – B

Subject to higher rate personal tax band

NIL

£40,500

Taken as capital gain

£40,500

NIL

CGT tax free allowance

(£12,300)

NIL

Amount subject to CGT

£28,200

NIL

Capital gains tax @ 10% with ER

(£2,820)

NIL

Dividend tax @ 7.5% – A

(£2,812)

(£2,812)

Dividend tax @ 32.5% – B

NIL

(£13,163)

Total tax

(£5,632)

(£15,975)

 

 

 

Qualifying conditions

 

Qualifying period

You must hold the company assets for at least two years. If the assets are shares of your personal company, the shares must be disposed of while the company is a trading company or within three years from the date it ceased to be a trading company.

 

Material disposal

You must hold at least 5% of the company throughout the two-year qualifying period:

  • Ordinary share capital
  • Voting rights
  • Distributable profits and assets
  • Proceeds of a company sale

Relief is also available if the company is dissolved with your share capital cancelled.

One exception is – if you are granted or acquired qualifying options (shares) under the Enterprise Management Incentive Scheme (EMI), you can qualify for ER without meeting the 5% rules above. You still need to hold the shares for at least two years before disposal, you must be an employee of the company, and the company must be a trading company within the period.

 

Definition of trading company

In HMRC’s definition, trade extends to almost any venture. E.g. contractors with personal companies in the field of IT consulting, design, and other professional services will all qualify. However, property investment is not a qualifying trade for ER. Many residential landlords use limited companies to save tax and expect to make healthy gains through house price appreciation. Unfortunately, when they exit these ventures and close the companies, they are unable to claim ER. However, there is a workaround. That is to conduct qualifying trading activities for a period of two years prior to closing the company. This is discussed in a previous article.

The company does not have to be a UK company to qualify for the ER.

 

Things to watch out for

 

Entrepreneurs can claim the ER for multiple companies, but life-time limit of £10 million applies.

For a sole director and shareholder of a personal company, if the retained profit is greater than £25,000 at the point of closing the company, they will have to close the company formally via the Members Voluntary Liquidation (MVL) route. Only then will they be able to pay CGT for the whole amount of retained profit and claim ER at 10%. The MVL process must be conducted by a licensed insolvency practitioner. If the director/shareholder chooses to strike-off the company informally, he/she can only pay CGT for £25,000 of the retained profit and will be forced take the remainder as dividend – incurring pay income tax at the applicable income tax rate.