You’re retiring soon and your fellow shareholders want to buy you out. The trouble is they don’t have the cash and paying you in dribs and drabs will cost you extra tax. How can you get your money out tax efficiently?
You’ve built up your company and more recently taken on additional directors with the idea that they will pick up the reigns. But now the time has come they can’t afford to pay you what your shares are worth. They have suggested the company buys your shares over the course of a few years.
Income tax trouble
You don’t mind waiting for your money as you have confidence that the business will continue to grow. The trouble is the money you receive from an instalment buy-out usually counts as income, meaning that you’ll lose 30.5% tax on most of it.
Capital gains tax joy
You would like the proceeds to count as a capital payment because the 10% entrepreneurs’ relief rate of capital gains tax (CGT) will apply. But, as pointed out above, where your company purchases shares from you, unless payment is made in full on completion the proceeds count as income. This isn’t HMRC being awkward, it’s actually a company law requirement. Apart from company law, HMRC sets its own conditions which must be met if a company purchase of own shares is to count as a capital transaction. You must apply to it for advance agreement, setting out the reasons for and the terms of the share buy-back. Instead of spreading the payment for buying back all the shares, you can spread the sale by selling them in stages. That can get you around the company’s lack of money, but there are more hurdles to clear.
Substantial reduction trap
One of HMRC’s conditions is that after you sell your shares to the company you must reduce your ownership of the company by 25%. For example, if you owned 50% of the shares before the sale, you must not own more than 30% of the shares after. But this percentage is worked out after the shares you sold to the company have been cancelled. So assuming 1,000 shares in total you would need to sell 200 to meet the 25% test.
The trouble with selling shares in stages is that their value will change each time, and so if the company performed badly the departing director might get less than they expected. Conversely, if the company performs well it will have to pay more for the shares, which will hit the remaining shareholders in the pocket. The solution is to draw up a sale contract for all the retiring shareholder’s shares at an agreed value, but with staggered completion dates. Because, for CGT purposes, the shares are treated as sold when the contract is signed (the completion date is irrelevant), there’s no problem with the 25% test. Plus, as the company will pay for the shares in full on completion there will be no problem with company law. The wording of the contract is vital, so get a company law expert to draft it.