Starting a new business is not an easy task, there are several challenges faced by an entrepreneur at the beginning of their start-up business but some go to succeed selling their businesses, this is where Entrepreneurs’ relief becomes important. This guide is broken up into several major sections including:
- Entrepreneurs’ relief explained (ER)
- Are you eligible for ER?
- How does entrepreneurs’ tax relief work?
- What assets qualify for ER?
- How to claim entrepreneurs’ relief
- How to calculate entrepreneurs’ relief
- Origins of Entrepreneurs’ relief
- The future of entrepreneurs’ relief
Entrepreneurs’ relief explained (ER)
There are many entrepreneurs who wish to sell or give away their business due to several reasons. Some simply do not have time to manage their well-established business while others are not satisfied with their company or business. Irrespective of what the reason may be, entrepreneurs may gain benefits by selling or giving away their business at a reduced tax rate. This benefit is called entrepreneurs’ relief.
To maximise your financial gains, you need to be aware of entrepreneurs’ relief (ER). If you’re eligible, ER is something you can claim as a way of increasing your financial gains when selling all or part of your business. In essence it allows you to apply a reduced rate of 10% capital gains tax on the profits you make when you sell qualifying assets (such as your business).
How much can you claim?
You can claim up to £1 million of entrepreneurs’ relief in your lifetime. You can claim as many times as you like, provided your claims are within this £1 million limit. This makes ER one of the most attractive tax benefits available to entrepreneurs.
Are you eligible for ER?
Entrepreneurs’ relief is available to individuals, but not to companies. There are certain requirements you need to meet as the person selling the qualifying assets in order to be eligible for entrepreneurs’ tax relief.
First off, to be eligible for ER, you need to meet certain conditions throughout what is referred to as the ‘qualifying period’. After 6 April 2019, the qualifying period equates to two years, ending with the date that the share disposal takes place. This means that all the following criteria must be met for the duration of the two-year qualifying period:
- You have been a sole trader, officer or employee of the company
- In this capacity, you have held 5% or more of the share capital of the company and 5% of voting share capital
- You haven’t exceeded your £1 million lifetime limit
There are also some notable differences in eligibility depending on whether you’re selling shares of your business, or whether you are disposing of the business altogether. Whilst both instances can qualify for entrepreneurs’ relief, be aware of the differences.
Selling the business
When selling the whole of or part of your business, you need to be the exclusive business owner (the sole trader) or a business partner for the duration of the qualifying period. You also need to have owned the business for at least two years.
In the case of selling shares, you need not be the company owner, but you must have been an employee or officer in the company, as well as holding the above share capital, for the whole of the qualifying period.
Additionally, to claim on disposal of shares, the company needs to be a trading company (or a holding company of a trading group) and needs to have traded within the qualifying period. To be a trading company, the company’s main activities need to be in trading. We’ll take a look at what qualifies as a trading company later on.
There is one major exception in relation to the qualifying conditions. There is one case in which you aren’t required to be working in the business: here, entrepreneurs’ relief extends to investors, under an extension called investors’ relief.
Under this initiative, capital gains made by investors will also only be taxed at 10% if they satisfy certain conditions. These conditions are largely the same as those corresponding to entrepreneurs’ relief, but with some minor changes (see Investors relief for more information).
Am I eligible for entrepreneurs’ relief according to HMRC?
When it comes to any kind of tax relief, it is easy to get caught out on a technicality. Care needs to be taken in the details. Entrepreneurs have been known to lose £1 million of tax relief due to an oversight on technicality! It’s therefore imperative that you check the HM Revenue & Custom’s definitions to check your eligibility.
To qualify as an ‘employee’ or ‘officer’ under the HMRC’s definition, there is no requirement with regard to your salary or hours worked as the claimant. They do, however, require evidence of you working in the business. This can be a written employment contract, for example. The HMRC’s definition of ‘officers’ includes non-executive directors as well as company secretaries.
HMRC’s definition of trading
In actual fact, there is no set definition of trading given by the HMRC. Instead, the company’s trading status is evaluated based on several factors. It’s worth noting that trade extends to any venture, which can mean a one-off transaction resulting in unexpected profits. Another important thing to note is that a company does not need to make profits to be trading. Trading at a loss will still qualify.
Many businesses operate with a mixture of trading and non-trading activities. Non-trading activities can include licencing arrangements, property development and investment. Companies with mixed business trading can still achieve active trading status, provided that these non-trading activities are not ‘substantial’.
The HMRC considers ‘substantial’ to be anything over 20%. For example, rental income is usually regarded as non-trading. A property company can still qualify as a trading company, and therefore claim entrepreneurs’ relief, provided that its rental income equates to less than 20% of the company’s total trade. HMRC also takes into consideration the time spent by staff on trading activities and the history of the company’s trade.
If your company is cash-rich, you should also take care when applying for entrepreneurs’ relief. Cash-rich companies risk failing the trading status test. In other words, HMRC could deem you a non-trading company if you have a lot of surplus cash. The 20% guideline applies again here: generally, if excess cash equates to 20% or less of the assets, then the company is still considered as having active trade status by HMRC.
It can get complicated if your business has a mix of trading activities or if your company is cash-rich. If you’re unsure on the trading status of your business, you can seek an opinion from HMRC. Whilst this won’t guarantee that the disposal qualifies for entrepreneurs’ relief, this can certainly improve your chances of securing entrepreneurs’ relief. Additionally, if the opinion isn’t to your favour, it allows you to make changes which will bring your business within an HMRC approved trading status.
Cessation of trade
There is one case in which the trading requirement does not apply. If the company has ceased trading over two years before the disposal date but within three years of the disposal date, and provided that the company satisfied the trading conditions for an entire year preceding the date of cessation of trade, you will still be eligible for entrepreneurs’ relief.
How does entrepreneurs’ tax relief work?
The clue is in the title, ‘relief’. Quite simply, a successful claim relieves the amount of tax you would usually have to pay. When selling any assets, you are subjected to pay Capital Gains Tax on the profits. ER works by relieving some of this tax.
What is Capital Gains Tax (CGT)?
When selling any form of asset, businesses are required to pay Capital Gains Tax on the profits. CGT applies to everyone, whether you are an individual or a company, and is applied when selling anything for more than you bought it for, giving you a financial gain. Most personal possessions worth £6,000 or more are subject to CGT, with the main exemption being your car. Any property (excluding your main home) is subject to CGT and, most pertinently for us, so are any business assets.
In business terms, CGT is a tax on any profit you make on the disposal of assets. This includes disposal of shares or business disposal, and even applies when giving an asset away as a gift (unless the recipient is a spouse).
How much is CGT?
You only have to pay Capital Gains Tax on your overall gains over your tax-free allowance, which is £12,000. Above this, the Capital Gains payable tax can be up to 28%, depending on what you’re disposing of and what income tax rate you pay. Most entrepreneurs will be looking at paying 20% CGT on chargeable assets.
By claiming entrepreneurs’ relief, you can reduce the amount of Capital Gains Tax you have to pay on the gains you get from selling your business. Entrepreneurs’ relief reduces the payable tax on gains to 10%. This tax relief results in huge financial gains for entrepreneurs.
What assets qualify for ER?
Entrepreneurs’ relief applies to any material disposal of business assets. These can be shares and securities. It does not, however, apply to the disposal of investment or non-business assets, such as personal assets.
What about EMI shares?
If the shares are from an EMI, they must comply with extra qualifying conditions to fulfil the requirements for an entrepreneurs’ relief claim. EMIs stand for Enterprise Management Incentives and are part of an initiative whereby UK employees can acquire shares. Statutory tax relief is provided on the financial gains of these employees on their shares, meaning they don’t have to pay income tax or National Insurance on their gains.
EMI options are only for smaller companies with assets of £30 million or less. If you are selling your EMI shares, you may still be liable to pay CGT, but therefore may also still be eligible for entrepreneurs’ relief. To be eligible, you must have:
- purchased the shares after 5 April 2013
- been offered the option to buy them at least 2 years before selling them.
Providing these qualifying conditions are met, you may still claim entrepreneurs’ relief for the disposal of EMI shares. The only exception is the requirement to hold 5% or more of the voting share; this does not apply when it comes to disposing of EMI shares.
One thing to bear in mind to maximise your entrepreneurs’ relief is that the £1 million limit is per individual. Additionally, Capital Gains Tax does not apply on gifts if these gifts are donated to spouses.
Therefore, if you are in danger of exceeding your ER allowance, it is worth considering transferring assets to your spouse in order to transfer the gain from one party to another. Providing they meet the qualifying conditions, they will now be eligible for ER if they are yet to reach their allowance. This enables you to maximise your relief! Just be sure to make sure that the gift is unconditional in order to qualify.
Can you claim entrepreneurs’ relief on property?
As we know, entrepreneurs’ relief reduces the payable Capital Gains tax on profits. If the property is your main place of residence and you have lived there throughout your ownership of the property, then it will be exempt from CGT, so claiming entrepreneurs’ relief won’t apply. CGT is applicable, however, for other residential property.
Whether entrepreneurs’ relief is applicable on commercial property is dependent on several factors. Firstly, has the company received any rent on the property in question? If the answer is yes, this property won’t be eligible for entrepreneurs’ relief, as the property will be considered an investment.
If not – great! The property is classed a business asset, and therefore might be eligible for entrepreneurs’ relief. The second factor to consider, then, is whether the sale of the property is associated with the sale of the whole or part of the business that the property is used in. If it is, then you can claim entrepreneurs’ relief on the sale of the property.
How to claim entrepreneurs’ relief
The claim must be made to HMRC. Most often, this is submitted as a claim on your annual Self-Assessment tax return. There’s a supplementary section entitled ‘Capital Gains Summary’, which will be covered in more detail below. Alternatively, you can fill in Section A of the HS275 form, although this is more complicated. It’s always a good idea to seek the advice of an accountant before you make a claim, to check you qualify and avoid any mistakes which could lose you your tax relief.
When do I need to claim?
A claim for entrepreneurs’ relief must be made before the first anniversary of the 31 January following the end of the tax year in which the relevant disposal takes place. So for a business disposal which occurred in the 2018 to 2019 tax year (any disposal made within 6th April 2018 and 5th April 2019), a claim for entrepreneurs’ relief must be submitted by 31 January 2021.
How to calculate entrepreneurs’ relief
As we have seen, entrepreneurs’ relief works by reducing the payable Capital Gains Tax on profits gained by disposing assets. Follow these steps to calculate entrepreneurs’ relief:
- Work out your total taxable gain by adding together all your capital gains, less any losses
- Subtract your tax-free capital gains allowance (£12,000 for individuals)
- You’ll now pay 10% on the remaining figure. The rest is yours!
Examples of entrepreneurs’ relief
Here are some examples of different cases where entrepreneurs’ relief can be claimed, to give you a better picture of how it works.
Example 1: Disposal of shares
Mr Knight owned some shares for 20 years in a company where he was the director. He owned 10% of the shares of the company, which entitled him to 10% of the voting rights. In October 2017, Mr Knight disposed of the shares, making a gain of £740,000. The company had been a trading company, but its trade ceased in September 2015, after which the company no longer qualified as a trading company.
In this example, Mr Knight still qualifies for entrepreneurs’ relief. The disposal was made less than 3 years after the company ceased trading. Mr Knight fulfils the qualifying conditions for entrepreneurs’ relief in that he holds over 5% of the company shares and voting rights. In this scenario, instead of paying £207,200 in Capital Gains tax (28% of his net gain) he will only pay £74,000 in CGT after claiming for ER. Entrepreneurs’ relief has saved him £133,200!
Example 2: Disposal of part of/all of a business
Mrs Dubois is a higher rate taxpayer and is the sole trader on a business venture that she built up from scratch. On 1 June 2019, she sells the business goodwill for £320,000. The buyer doesn’t want to acquire the office buildings, owned by Mrs Dubois, in which the business is run. A few months later, Mrs Dubois sells the offices making a capital loss of £60,000. She also makes a capital gain of £20,000 on the disposal of a painting, unconnected to her business.
How do we work out how much entrepreneurs’ relief Mrs Dubois can claim, and what her resulting capital gains tax position will be for 2019/20? Firstly, we can disregard the £20,000 she made on the painting from the entrepreneurs’ relief, as this is not a business disposal. Her net gain on business disposals will be £320,000 less £60,000. This means that her net gain is £260,000, eligible to entrepreneurs’ relief, reducing her CGT for this amount to 10%, which equates to £26,000.
To work out her overall capital gains tax position, this will include her non-business disposal. Her gain on the painting was £20,000. £20,000 less the annual exemption of £12,000 gives £8,000. The payable CGT for this sum will be charged at 28%, giving £2,240. So her total capital gain tax liability for the 2019/20 year, after entrepreneurs’ relief, is the sum of these two totals; £28,240. This compares to £75,040 without entrepreneurs’ relief – gaining her £46,800!
These examples indicate the enormous financial gain to be made if you’re eligible for entrepreneurs’ relief, which is what makes it such an attractive tax benefit. It’s therefore no surprise that in the 2015/16 tax year, according to HMRC statistics, 52,000 taxpayers claimed entrepreneurs’ relief on £25 billion of capital gains.
What if my company is dissolving?
Entrepreneurs’ relief can still be claimed if you intend to close your limited company, provided that the following criteria are met:
- The distribution of any company assets must be taxed as a capital distribution, not as income
- Distribution must take place within three years of the date of cessation of trade
- In the two years prior to the company ceasing to trade, the usual qualifying conditions (as listed above) were met.
Similarly, if you are closing your business, you also need to fulfil the same requirements, as per the qualifying conditions, as you would if you were selling all or part of your business: you must either be the sole trader or business partner, and must have owned the business for at least two years.
When closing your business, the alternative to paying Capital Gains tax is to eke out your profits over several years with a traditional small salary of £11-12K per year, plus a Basic Rate dividend (around £33,000 per year), on which only 7.5% dividend tax is payable. For many businesses, it is far more tax-efficient to pay a flat-rate of 10% Capital Gains tax (reduced with entrepreneurs’ relief) on the company’s profits and access the gains straight away, rather than the traditional small salary method. However, it is worth getting an accountant to evaluate this for you first.
Targeted anti-avoidance rule (TAAR)
On this note, it is important to be aware of new legislation aimed to target business closures as a way of reducing tax. If you are closing your limited company by the route of Members’ Voluntary Liquidation, be aware of the new Targeted Anti-avoidance rule (TAAR) introduced by HMRC which took effect in April 2016.
With an MVL, all the company’s assets are turned into cash and distributed to shareholders. These distributions are taxed as capital gains, which makes them eligible to entrepreneurs’ relief. However, this new rule prevents individuals from closing companies simply as a way of taking advantage of the tax efficiency of the capital distribution route, rather than an income distribution.
Distributions from the voluntary liquidation of a company may be treated as income distributions in the following circumstances:
- If the company is a ‘Close company’ (a company with five shareholders or less)
- If the shareholder receiving the distributed is involved with a similar trade or activity within two years
- If the intention of winding-up the business appears to be to obtain a tax advantage.
In these instances, the distributions could be subject to income tax, and ineligible for entrepreneurs’ relief.
Origins of Entrepreneurs’ relief
Where did entrepreneurs’ relief come from? Entrepreneurs’ tax relief was introduced under the Labour party government in 2008, to take effect from the 2008/09 tax year. It was introduced primarily as an incentive for people to establish businesses in the UK by reducing the rate of Capital Gains Tax on business disposal.
This meant that from April 2008, qualifying individuals would only pay a reduced CGT of 10%, as opposed to the standard 18%, or higher rate of 28%. Initially, the entrepreneurs’ relief was limited to £1 million (it has recently reverted back to this figure from £10 million).
Changes to ER
Since 2008, there have been considerable changes to this amount.
- In March 2010, the entrepreneurs’ relief was up to £2 million
- Three months later, it was raised to £5 million
- In March 2011, the budget was then raised to £10 million.
- In March 2020, the budget was then lowered to £1 million
It is believed that through facilitating entrepreneurs, entrepreneurial culture is to be given a boost which will eventually contribute towards the creation of more job opportunities and acceleration of economic growth.
As the significance of entrepreneurs’ relief for supporting economic growth has been widely acknowledged, the government has taken the initiative to provide further support to entrepreneurs under this policy. The rate of capital gains tax has been reduced to 10% for lifetime capital gains that are within the limit. This modification in the policy has particularly benefited established entrepreneurs, who now wish to explore new pastures or are thinking about retiring.
Sale of loan notes
A major impact of the changes to CGT in recent years concerns the eventual CGT position of loan note holders. Those entrepreneurs who might have exchanged their shares that qualified for entrepreneurs’ relief for business loans are advised to re-examine their CGT positions at the eventual sale of their loan notes. There are chances that if the loan note holders proceed to sell these possessions, they may be liable to pay CGT at an increased rate, rather than the expected rate of 10%.
FA 2014 and 2015 goodwill changes
The 3rd December 2014 saw the introduction of new rules which affected the eligibility of sole traders and partnerships claiming for entrepreneurs’ relief. These new rules prevent sole traders and partnerships from claiming ER if they sell their business to a company in which they have 5% or more of the share capital or voting rights
The future of entrepreneurs’ relief
In the 2019 general election, entrepreneurs’ relief came under fire in both the Labour and Conservative manifesto. Whilst Labour was looking to scrap ER entirely, the Conservatives pledged to review and reform the scheme.
This could have an impact on entrepreneurial activity in the UK. The UK, and especially London, has even been called the world’s best start-up centre. Entrepreneurs’ relief reducing CGT to 10% certainly makes the UK a hugely attractive location for entrepreneurial activity.
However, whilst the UK can definitely at minimum anticipate some changes to ER, it is unlikely that the tax benefit will be scrapped with no alternative. Tax breaks are a way of the government attracting and, more importantly, retaining talented business people. In short, it’s in the government’s best interest to assist entrepreneurs.
One of the main criticisms of the current ER structure is that many of the claimants do not represent ‘true’ entrepreneurs. Rather, there’s wide-felt sentiment that many people applying for ER are already wealthy individuals simply seeking to reduce their tax bill. It’s therefore likely that any reformations that come under the Conservative government will restructure the system to protect what they consider to be ‘true’ entrepreneurs and sew up the current loopholes.
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The next few years will undoubtedly bring some changes to entrepreneurs’ tax relief in one way or another (the result of the above was that the scheme was reduced in 2020 to £1 million.). This is important to keep in mind if you’re looking to sell business assets in the next few years. Keep up to date with the latest legislation – and contact HMRC in any doubt. In the meantime, save yourself hundreds of thousands by claiming for entrepreneurs’ tax relief!