Overview
New businesses need to think about tax from the outset to avoid tax problems later. It is important to choose the right entity for your start-up whether it is sole proprietor, partnership, or some form of corporate body. We can advise on the advantages and disadvantages of each before making this choice and whether reliefs such as SEIS and EIS may be available.
It is important to incentivise and retain key employees and there are a number of tax efficient ways to achieve this. We can discuss with you the tax advantages of different share option schemes and which may be the most appropriate for your business.
FAQs
What are the key tax differences of operating as a sole trader or a limited company?
(a) Sole Trader
Tax on profits:
You pay Class 2 & 4 National Insurance and Income Tax on the taxable profits of your business, or your share of profits, if you are in partnership.
Extracting profits
You may withdraw cash from the business without tax effect.
Selling the business
When the business or assets used in it are sold, you are personally taxed on any gain under the Capital Gains Tax (CGT) rules.
A disposal of an interest in a business or a disposal of business assets may qualify for Business Asset Disposal Relief.
(b) Limited company
Tax on profits:
- The company pays corporation tax on its taxable profits. Company tax rates are lower than higher rates of Income Tax.
- Employees and office holders are subject to PAYE and NICS on their earnings from employment and many benefits attract income tax too.
- Shareholders are subject to income tax on dividends.
Extracting profits
You are taxed on:
- Any income withdrawn from the company. If it is a distribution it is taxed as a dividend. If it is earnings it is under PAYE and subject to NICs.
- Most employment benefits received by you or your family and household are taxable (subject to tax-free exceptions).
- Shares or securities in the company which are given to you at less than market value.
Selling the business
When the business or the assets used in it are sold, there is a double tax charge on shareholders. The company pays corporation tax on any profit that it makes on disposal. The shareholders are taxed on the distribution of the proceeds taken out of the company by declaring a dividend.
It may often be more efficient to sell the shares in a company, rather than its trade or business, or individual assets. Providing you own more than 5% of the shares in a trading company and voting powers for at least 2 years, a disposal with gains of up to £1 million may qualify for Business Asset Disposal Relief.
What is SEIS and EIS relief?
Under the Seed Enterprise Investment Scheme (SEIS) new companies can raise seed capital. It provides 50% tax relief for investors investing in start-up companies, with also a generous Capital Gains break:
- The maximum amount an individual can invest into an SEIS company is £100,000 per tax year.
- The maximum amount of investment that a qualifying company can receive is £150,000 in any three year period.
The Enterprise Investment Scheme (EIS) provides tax incentives in the form of a variety of tax reliefs to investors who invest in smaller, unquoted, trading companies.
- The maximum amount an individual can invest into an EIS company is £1 million per tax year, where the income tax liability of the investor can be reduced by 30% of the sums invested up to the £1 million limit.
- The maximum amount of investment that a qualifying company can receive is £5 million (or £10 million for knowledge intensive companies).
What are EMI schemes?
(a) Scheme
Enterprise Management Incentive (EMI) Schemes are approved share option schemes, where the company can grant share options to its qualifying employees with certain tax advantages. An employee share option is the right to acquire shares in a company at a pre-set price.
(b) Tax treatment
There is no income tax liability on granting the option.
There is no income tax liability on exercising the option (as long as the employee pays an exercise price that represents the market value of the share at the time the option was originally granted).
On sale of the option shares, CGT may be payable on any gain over the market value at grant (ie the difference between the sales proceeds and the market value of the shares at grant).
Shares acquired on exercise of an EMI option qualify for Business Asset Disposal Relief, provided conditions are met and the holiday period for the option contributes towards the two year holding period for the relief to apply.
What are the requirements for Business Asset Disposal Relief (BAD Relief)
You can claim BAD Relief (which reduces the rate of capital gains tax you pay on the first £1 million of gains you make in your lifetime to 10%) for disposals of any of the following:
- all or part of a trading business;
- the assets of a trading business after it has stopped trading; and/or
- shares in a trading company (or holding company of a trading group).
You can claim relief on proceeds from a partial or full sale of a business, shares in a company, or on the value of any business assets remaining after the company has ceased trading.
The relief is available for you as an individual if you:
- are in business, for example as a sole trader or as a partner in a trading business; or
- hold shares in your personal trading company (or holding company of a trading group).
In order to claim BAD Relief several conditions must be met:
1. You must have owned the business (or the shares) for 24 months before claiming the relief, or for 24 months before the date the business stopped trading.
2. It is essential that the business must be a trade and the activities must not include any non-trading activities that are substantial. The word “substantial” is not defined but HMRC accept that non-trading activities that make up no more than 20% of a business will not debar a claim for BAD Relief. When considering this test surplus cash can present problems. Cash that is not required as working capital or earmarked for capital expenditure or future business investment, may risk loss of BAD Relief as a substantial non-business asset. If you are building up cash reserves for a major purpose keep records of meetings and research done into possible acquisitions to prove that the money is retained for business purposes. This test must be passed throughout the 12 months before you want to claim BAD Relief.
3. If claiming BAD Relief on shares, a shareholder can qualify for BAD Relief as long as the company is their personal company. This means that for at least two years ending with the date of the disposal, the shareholder has been a director or employee, and has owned at least 5% of the ordinary share capital carrying at least 5% of the voting rights. Once the 5% test is passed other shares such as preference shares and certain types of loan note (non-qualifying corporate bonds) can also qualify for BAD Relief.
4. If claiming BAD Relief on shares it is important to remain an employee or an officer until the date the shares are sold. Therefore, if contemplating withdrawing from a business any resignation should not become effective before the contract for sale of the shares has become unconditional. Similarly, a non-employee shareholder (e.g. a spouse who owns shares but is not an employee) who meets the 5% test can qualify for BAD Relief by making them an employee or office holder (usually company secretary). There is no minimum working time condition, so long as the employment or office genuinely exists.