Turning accumulated profits into gains to save tax

Profit sharing and accumulation

A relatively simple and well used income tax-saving strategy for owners of companies is to share the income between spouses (or civil partners), especially where one of them pays tax at lower rates than the other. A potential drawback to this arrangement is that it can negatively impact business asset disposal relief (BADR) (formerly entrepreneurs’ relief (ER)) when the company is sold at a gain or wound up and accumulated profits taken by the shareholders as capital.

Failing to meet BADR conditions

For a capital gain to qualify for the BADR special tax rate (10%) a shareholder must have owned their shares in the company for at least two years. Plus, at the time of sale they must be an employee or officer (a director or company secretary) and been so for at least the two years leading up to that date.

The no-employment trap

It’s vital that the two-year employment/company officer condition must be met at the time the sale of shares is agreed. If you’re winding up your company, it must be met at the date the winding up process starts. If you resign the day before the deal is done you’ll lose all your entitlement to BADR . This trap catches more people than you might think, especially where a company is being sold. This is because new owners often require the shareholders to resign their directorships or employments before the contract for the sale of shares is signed.

In the case of Kennedy v HMRC 2021 the taxpayer lost out on BADR (ER) for not meeting the employment/company officer condition. He was working for the company when the sale of shares was agreed but only in the capacity of a freelance consultant. This didn’t meet the employment condition.

Avoid the trap by negotiating that you remain a director until the contract to sell your shares is signed. If that’s not feasible or is unacceptable to the purchaser, negotiate a minor role as an employee of the company or a company in the same group. The employment/company officer condition for BADR is met even if the employment is unpaid. Make sure you have paperwork, e.g. a contract of employment, to prove the arrangement to HMRC if necessary.

Too late to be employed

If one of the spouses or partners is not an employee or company officer at the time the company is sold or wound up, they won’t qualify for BADR on any capital gains. It won’t help to make them a director or employee just before the sale as the two-year condition won’t be satisfied.

If you or your spouse or partner don’t meet the conditions for BADR but the other spouse or partner does, the one not meeting the condition should transfer their shares to the other before the sale or winding up. The rules will allow BADR for their entire shareholding as at the date of sale etc. even for the shares they owned for less than two years.