Entrepreneur’s Relief: ensuring change isn’t taxing

Wednesday March 18, 2020

Mitigating the Chancellor’s changes to Entrepreneur’s Relief

Recent world events, specifically the ongoing pressures caused by COVID-19, have brought new headwinds for businesses up and down the country.

Against this backdrop, some of the developments announced in last week’s Budget may not have been as high-profile as they may otherwise have been.

But with current trading conditions set to persist for some time, it’s important that businesses take the time to review what key changes will mean for them over the longer term, and factor this into their own – likely now fluid – business plans.

Entrepreneur’s Relief – change afoot

One of the headline changes in the Budget was a cut to Entrepreneur’s Relief – a measure that enables business owners to pay just 10 per cent Capital Gains Tax (CGT) on a proportion of the profits from the sale of their companies.

Following much speculation that the measure would be abolished altogether, the new Chancellor Rishi Sunak instead announced a 90 per cent reduction in its lifetime limit, from £10 million to £1 million – a move designed to recover funds for the Exchequer while retaining an incentive for entrepreneurs to start and grow a business.

Although the Chancellor was quick to point out that the government expects 80 per cent of firms to be unaffected by the changes, some business owners will be weighing up how the change could affect them, both now and in the future.

Ultimately, the development means that those who generate profit on the sale of their business exceeding the £1 million limit will likely face higher tax charges.

While it’s a factor that will need to be considered, it’s one that needn’t derail longer-term exit strategies with the right forward planning.

Given the economic climate, and this change, owners should keep the longer-term picture in mind as they assess their plans for a sale and consider the full range of options that will enable them to maximise the value they can unlock in the future.

Planning ahead

Key to developing an effective exit strategy is assessing the capital an owner needs to fund their lifestyle or to fulfil their own financial plans. This is important in determining how much an owner needs to generate from exiting their business, along with how and when they choose to do so. The focus is often only on the net proceeds that will be achieved from the sale process rather than taking a holistic view of their financial position.

As a business is often just one of an individual’s assets, an important early step in their exit strategy is therefore to determine how the business fits within their wider personal financial picture.

Owners can then design and implement a growth plan to build the capital value of the business that works towards their financial goals, while also compensating for the additional tax liabilities they may now incur.

Given current conditions, some may well not be planning an exit in the immediate future, but others may be looking to release equity much sooner once the markets return to normality.

For those concerned about receiving diminished value by selling now, there are options that could help release funds while ultimately generating greater value than they would have done through an immediate sale. This will potentially help offset any additional tax they have to pay and address any potential dips in value caused by current trading conditions.

Partial exits

One such option is a partial exit. This involves arranging the succession of a business from an owner to the management team over a number of years, typically in two steps, allowing the owner to retain an equity stake at step one that is then released at step two as the stake is either purchased by the management team or the business is sold to a third party.

If the business has grown between the first and second steps, it is possible that the value of the retained stake will have risen over the transition period, enabling the owner to release a value that is, in sum, greater than that of an equivalent outright sale at the start of the process.

A partial exit can provide real alignment of goals between owners and management. This can prove even more vital during challenging times, while rewarding all. If it goes well, the increased value achieved should more than compensate for the additional tax liabilities.

Employee ownership trusts

Another option would be to create an ‘employee ownership trust’ (EOT) – a model deployed by businesses such as Richer Sounds.

This effectively sees owners sell a controlling stake in their business to a trust benefitting their employees. It offers the advantage of being highly tax efficient – notably, owners selling their stakes through this option won’t incur CGT – as well as seeing control pass to the people who already have a vested interest in continuing its success.

Those considering an EOT may want to first ensure that they’ve developed, and can demonstrate, a sound forward management strategy. Any investors or lenders involved in the process will seek evidence that a business’ future direction is in the hands of a truly motivated and incentivised management team.

For those who are considering an EOT but are out of step with their management teams, now would be a good time to ensure that their interests and strategies are fully aligned.

Conclusion

Business owners are undoubtedly operating in an uncertain, challenging environment. However, by considering the full range of solutions available, they can still develop an exit strategy that builds capital value, incentivises the key stakeholders in their business and ultimately delivers on their target exit value.