Technical: Income and tax planning after a business sale
15 May 2019
A business sale is, for most clients, a major financial event, with owners often spending a couple of years preparing their business for it. But, this should also be a time where people prepare their personal finances for post-sale too, says David Wright, Wealth Management Consultant, Mattioli Woods
When business owners prepare for the sale of their business, with retirement in view, often their focus can be on that event at the expense of preparing their personal finances, which inevitably will be impacted by it. Obvious planning considerations will be their income in retirement, for example, or perhaps the inheritance tax (IHT) implications? As always, good planning is required – this time to take full advantage of the business sale to ensure their needs are met.
For most clients, a business sale will herald the beginning of their retirement. The income they have previously drawn has typically comprised largely of dividend payments, and such clients are probably used to a high degree of flexibility in terms of what they draw and when. Such income will cease following the sale of the business and the client will become reliant upon the measures they have (hopefully) put in place over their lifetime.
For most, such measures will focus on one (or more) pension schemes. An ideal scenario often involves a pension scheme sitting alongside other structures to provide multiple income sources in retirement. This can be especially relevant for those subject to the tapered annual allowance, where the amount that can be contributed to a pension scheme is reduced.
In this scenario, ISAs are an obvious alternative to a pension scheme. The tax treatment of returns within an ISA allows for easy comparison to a pension scheme, while the lack of a minimum withdrawal age can make them more attractive when locking away funds in a pension would not be appropriate. The tax-free nature of all withdrawals, however, is crucial for generating an income in retirement.
For clients with an appropriate risk profile, venture capital trusts (VCTs) can provide a core element of a long-term income strategy and can be particularly useful where a business sale is on the horizon.
The headline feature of VCTs is often the 30% relief to income tax that applies upon investment. It should be argued that, while this is attractive, and could be viewed as making up for tax relief not received had the funds instead been contributed to a pension scheme, the real benefit of VCT investment comes in the form of tax-free dividends. If VCT dividends are reinvested until an income is required, this will deliver a greater capital value at the time the dividend ‘tap’ is turned on.
Incorporating VCTs into a strategy leading up to a business sale can effectively mitigate a major downside to VCTs, namely the under-developed nature of the secondary market. When a VCT is bought ‘second hand’, the initial tax relief does not apply. As a result, they tend to trade at a roughly 30% discount to their face value, assuming a buyer can be found. The receipt of a lump sum following a business sale can effectively negate the need to draw down the capital value of VCTs. Instead, they can be used as a purely income-generative asset and passed down to the next generation.
Putting this into practice
Let’s consider a case study. A client has been drawing £250,000 from their business annually. Their assets comprise company shares valued at £5 million and a main residence, but no pension exists. The client wishes to sell the business in 10 years’ time, but between now and then wishes to save, in some form, £5,000 per month.
Given the client’s level of income, the annual allowance for pension contributions will be tapered down to £10,000. This doesn’t mean making pension contributions at this level is not worthwhile, however. The tax-privileged nature of investment returns often makes pension schemes worthwhile, even where the annual allowance is less than what could be contributed. Indeed, when drawing an income in retirement, a pension scheme sitting alongside other vehicles provides for greater flexibility.
It is also worth noting the value of residual (DC) pension funds on death are outside one’s estate, and therefore free of IHT. Given that, following the business sale, we would expect there to be concerns around IHT, it may be the pension scheme is not drawn down, instead serving as a multi-generational vehicle.
With the ISA allowance currently at £20,000, it would make sense to maximise this, especially as once a tax year has passed, there can be no carrying forward of unused allowance. Over a period of ten years, assuming a return of 5% per annum, an ISA could be expected to have a value of circa £260,000 if the allowance is maximised each year. Therefore, if we look to draw only the growth accruing to the ISA each year following the ten-year investment, this would generate £13,000 of tax-free ‘income’. This would provide for a foundational level of income in retirement, leaving the personal allowance fully intact.
With £30,000 remaining to be placed somewhere, VCTs could be the perfect destination. Let’s say this is invested over three VCTs, increasing the level of diversification in the wider portfolio, and that this continues over the ten years leading to the business sale. Assuming the dividends are ‘rolled up’ and there has been an average growth rate of 5%, we could expect a capital value of circa £390,000 at the time of the sale.
In each year of investment, the client would enjoy £9,000 of relief to income tax. Upon turning on the dividend tap, an additional £19,500 of tax-free income would be generated, again leaving the personal allowance intact.
Strategy à la carte
Of course, while the client’s income requirement depends on their circumstances, the above strategy, while somewhat of an extreme case, would deliver circa £32,500 in tax-free income without depleting the capital value of either the ISA or VCT portfolio. Crucially, the full business sale proceeds (less tax) have yet to be used.
Plus, if further income is required, the client could look to invest some of the sale proceeds in ways taxable to each of their now-unused tax allowances (i.e. the income tax personal allowance, the dividend allowance and the capital gains annual exemption). If maximised, this could provide for an additional £26,500 of ‘income’ with no tax liability, in the current tax year.
In reality, a much more comprehensive account of the client’s circumstances and objectives would be taken, while more tools (and other concerns) would be considered. There is no set course of action to be deployed in the case of a business sale, but it is important to consider all available options. IHT, for example, is likely to be a key area of consideration – typically, this results in a major portion of a client’s estate losing access to business relief. Therefore, it may be wise to take measures to mitigate this.
Hopefully, what is clear is that planning in advance of a business sale can yield valuable results in delivering a highly tax-efficient income – the longer such a strategy can run for, the greater its likely impact.
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