Entrepreneurs’ Relief (“ER”) exists as an incentive for founders and owner-managers to invest in their own enterprise – with the attraction of a substantial tax relief on disposal of their shares or the company as a whole. But with recent changes to the ER rules, many directors and shareholders are failing to meet the new criteria for claiming the relief.
So, how do you ensure that you don’t miss out on the benefits of ER?
Gary Staunton, Partner at Haines Watts London, gives an overview of how ER works and the key ways to safeguard being eligible for the relief.
What is Entrepreneurs Relief?
Entrepreneurs’ Relief (“ER”) is a tax relief for people selling business assets or a company. As such, ER is a relief that’s open to directors, shareholders, sole traders and partners – although it’s generally not so well-known that sole traders can claim the relief.
The relief entitles you to a reduced Capital Gains Tax (CGT) rate of 10% instead of 20%, a benefit which could, potentially, save you £1M in tax over the lifetime of your investments. However, there are several criteria to meet if you’re going to qualify.
If you’re a sole trader then you just sell your business – and that’s pretty much the only stipulation. But for directors and shareholders of Limited companies, things are more complex.
To qualify for ER as a director/shareholder you must:
- Be an officer or employee;
- Hold at least 5% of the shares as well as at least 5% of the voting rights;
- Have a right to at least 5% of the company’s assets on a winding up;
- Have a right to a dividend of at least 5% of the income that’s available for distribution; and
- Have done so for the period of two years prior to the sale of your company or it ceasing to trade.
Rewarding and incentivising entrepreneurs
Why does ER exist? In essence, ER is there to reward individuals who take a risk and set up a new enterprise. By investing their money, they’re building up a business, employing people and adding to the country’s overall gross domestic product (GDP).
Starting any new business has an inherent risk. So, the reduction in your CGT rate gives you, as an owner and entrepreneur, a reward at the end of the process when you sell up.
The new rules are there to make sure this relief isn’t abused, so the circumstances under which you sell up are important. For example, if a larger company buys a smaller competitor and your business is bought out, you’ll generally qualify for the relief. But if you wind the company down, you may not qualify. These anti-abuse rules come into play to ensure that angel investors and venture capitalists don’t abuse it – but they can also act as a trap for unwary owner-managers who haven’t drilled down into the specific ER criteria.
Ensuring you don’t miss out on Entrepreneurs Relief
Making sure you don’t lose out on ER can be a significant issue for owner-managed businesses. If you open yourself up to not qualifying, and don’t get the right advice, you may well fall into one of the many traps – which can be a costly error!
In my experience of working with a wide range of startups and established owner-managed businesses, there are two main areas where owners are not qualifying:
1. Not having the right structure for your investments
If you have a trading company (but not a separate investment company) and the company is quite successful, you’ll have made profits and may well have generated surplus cash that you’ve invested in stocks, shares, property etc. – something which can create problems.
- Carrying out this kind of investment activity can mean you don’t qualify for ER, as it’s possible that it won’t be classed as acceptable trading activity by HMRC.
- Setting up the right group structure may be the answer to this but creating a clean and organised group structure is complicated and needs HMRC clearance.
Investing surplus profits, even through a group, may mean HMRC think you’re not a trading company. A group structure can be helpful but may also result in you not having full access to all your company funds.
- Creating the ideal structure needs to be dealt with properly by a tax advisor who knows the ideal set-up and can get HMRC clearance.
Ultimately, it’s about weighing up the different routes and seeing where you get the best return. Is it worth it? If your return is only a few thousand, is it worth jeopardising your ER?
2. Not managing your shareholdings effectively
As we saw in the rules above, you need to own 5% of the company’s voting shares to qualify for the relief – so it’s important to keep on top of share ownership and manage this well.
- When you bring in new shareholders, it’s vital to make sure that everyone still retains 5% of the total share ownership.
- In basic terms, you need to keep each slice of the pie the right size, so everyone continues to meet that 5% ownership criteria and qualify for ER. Alternatively, if you set-up the right share option scheme then you can give away much smaller pieces of the pie but still get everyone to qualify for ER – even if they do not get the actual shares until only minutes prior to the sale taking place.
Most business owners are not fully aware of the proper ER guidelines, so getting the right legal, tax and financial advice is highly advisable.
Helping you meet the ER criteria
In general terms, most owner-managers WILL meet the standard ER criteria. If you’re building up your business to be a success, it will take more than 2 years, you will be a director and you will earn more than 5% of the sale value. That’s standard.
The difficulties usually appear around investments and wealth planning – for example, when you’re looking to pass on company shares to family and children, or if you’re gaining income from a buy-to-let property, where this is classed as investment income.
We have a track record of working with owner managers to secure ER and doing everything in-house. We can help you with restructuring, legal requirements, issuing shares and any new company incorporations.
Talk to us about your ER planning.
ER is for business owners who aspire to sell on their successful business in the future, and who want to benefit from paying half the usual CGT. If you sell for £10M, that’s a £1M tax bill instead of a £2M bill – a tax cut that will make a significant difference to your bank balance.
We’ll ensure that you meet the ER criteria, that you plan ahead for any investment activity and that you have full access to the Haines Watts network – giving you the right tax and legal specialists to set things up correctly.
Talk to us about meeting the ER criteria.
We are a firm of London accountants, tax and business advisors working with OMBs and individuals.
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