First, what is Entrepreneur’s Relief (ER), and how does this work? Further to this, how does Entrepreneur Relief for contractors work when a contractor closes down their limited company due to having finished contracting? Furthermore, how do you qualify for Entrepreneur’s Relief when the time comes round to closing your limited company?
Important to note, Entrepreneur Tax Relief (UK) is available to you as an individual when:
- You sell all or part of your business as a sole trader or business partner.
- You dispose of or sell shares in all or part of your business (limited company).
As a limited company contractor, you may be able to claim Entrepreneur’s Relief when your personal company has ceased trading, and you dispose of your shares as part of your company’s closure. In turn, tax relief can be claimed, and the Entrepreneur Tax Relief will reduce the amount of Capital Gains Tax (CGT) that you will pay as part of the final payout from your company.
After a recent change, Entrepreneur Relief (UK) is now called Business Asset Disposal Relief (BADR).
Contractor/business owner timeline
As a limited company contractor, once you have decided to close your personal company, the following steps to take are:
- Ask your accountant to prepare and finalise the company’s final set of accounts up to the date it stopped trading.
- File the final accounts and a company tax return with HM Revenue & Customs (HMRC).
We now turn to the balance that remains in the business. This might be a large amount of cash on some or even many occasions. The remaining balance is payable to the shareholders in their respective share ratios.
How the final balance can be paid
The final balance is payable as either dividend or as Capital Distribution. It is also payable as a mixture of these methods.
The dividend route, in most cases, will be far more costly. The highest tax rates on dividends are currently 33.75% or 39.35%.
So, most contractors and small business owners will opt for the Capital Distribution route.
When your company distributes the Capital Distributions, the shareholders dispose of their share capital.
Entrepreneur Tax Relief when closing company
If you qualify for Entrepreneur Tax Relief (please see the three conditions in the next section), the CGT rate is 10% on any Capital Distributions. Under CGT rules, individuals currently have an annual CGT allowance of £12,300. So, suppose in the year of your company’s closure, the shareholders each have no other capital gains. In that case, the first £12,300 of your and any other shareholder’s Capital Distributions will be tax-free. If you are eligible for HMRC Entrepreneur’s Tax Relief, any additional Capital Distribution amounts above £12,300 will be taxable at 10%.
The income tax rates you pay do not affect ER or BADR. Therefore, basic, and higher-rate taxpayers will pay tax on their Capital Distributions at 10% if they meet the qualifying conditions.
Claiming for ER (BADR)
HMRC Entrepreneur’s Relief conditions
There are three main Entrepreneur’s Relief qualifying conditions that you need to meet when you close your contractor limited company. Therefore, you will qualify for Entrepreneur Relief (limited company) when you sell or close your business if you meet the following Entrepreneur Relief qualifying conditions:
- The individual disposing of the shares must own at least 5% of the shares in the company. They must also have 5% of the voting rights.
- When disposing of the shares, you must be either an employee of the company (please note, this includes being a company officer, e.g., a director) or else you must be a sole trader. You must also have been so for at least 24 months leading up to the date of the disposal.
- The business must also have been a trading company for at least 24 months leading up to the date of the share disposal (entrepreneur’s relief -trading company).
Under HMRC Entrepreneur’s Relief conditions, when you close your company, you must also dispose of your business assets within three years to qualify for relief.
Please note that you could also lose a claim for ER if you resign as a director before disposing of your shares.
ER may also be available when someone is selling their business or part of their business. This includes both certain assets within a partnership or indeed shares or securities in your company.
There is no limit on how many times you can claim ER. The Lifetime Limit of £10 million was reduced to £1 million in the March 2020 Budget.
How to claim Entrepreneur’s Relief on Self-Assessment
This will usually be a task for your accountant however when completing a tax return this needs to go in the Capital Disposal section. This will be part of the Capital Gains Tax Area on the tax return. The actual gain will be the final pay-out from the company less the cost of the original shares that were disposed of when the company closed. You will then need to indicate that the gain is subject to Entrepreneur’s Relief within the Capital section.
The time frame to claim Business Asset Disposal Relief (BADR / ER)
Please note, to be able to claim tax relief under BADR / ER, you will need to do this within a specific time frame:
- 2020/21 tax year (year to 5 April 2021) -31 January 2023.
- 2021/22 tax year (year to 5 April 2022) -31 January 2024.
- 2022/23 tax year (year to 5 April 2023) -31 January 2025.
Please note that you can claim for ER in the `Capital Gains Summary’ section of your Self-Assessment Tax Return.
Indeed, it would help if you spoke to your accountant about this to ensure that you report it correctly.
HMRC Entrepreneur’s Relief anti-avoidance measures
Anti-avoidance measure `phoenixism’ -Entrepreneur’s Relief 2-year rule
HMRC brought in a TAAR (Targeted Anti Avoidance Rule) in April 2016. With the update from ER to BADR this is now known as Business Asset Disposal Relief anti-avoidance.
This scenario applies to `close companies’ with five or fewer shareholders. It also applies to any number of shareholders who are company directors. The shareholders also need to have received a distribution from their company. Therefore, this is capital rather than income to obtain a tax advantage.
The Entrepreneur’s Relief 2-year rule is a measure which applies to a distribution made when a company closes.
The distribution will be income (not capital) where you meet the following conditions:
- An individual who is a shareholder in a close company receives from this a distribution in respect of shares in a winding-up.
- Within two years after the distribution, the individual continues participating in a similar trade or activity.
HMRC brought in this Entrepreneur’s Relief 2-year rule measure to target individuals who are closing their company and setting up another company again soon after. `Phoenixing’ is the term given when taking advantage of the tax efficiency of the Capital Distribution route.
A further HMRC measure regarding ER -`money boxing’
There is a second less well-known HMRC measure. This measure is called `money boxing.’ The term relates to the deliberate building up of cash in a company until it finally closes down. There is no actual legislation as such to counteract this.
If the amounts involved are a) significant and b) the retained profits are being invested, rather than being held in a short-term deposit, HMRC may try to deny Entrepreneur Tax Relief because the business is no longer a `trading company.’
Whether you are an employee of the company or not, you will need to ensure that you are a) a director and b) own at least 5% of the shares and voting rights and c) your business has been trading for at least 24 months to qualify for ER and d) when you close the company, you must dispose of your shares within three years of the company finishing trading.
When you close your company, you must consider the best route. It may be better for you to take all of the final balance as a Capital Distribution. On the other hand, it may be better for you to take a mix of dividends and Capital Distribution. If you are unsure which of these is best for you, please check this out with your accountant. They will be able to look at the overall picture and find the best way for you.
Link to Contractor Advice UK group on