Tax-Efficient Extraction of Capital Gains for Sole Traders and Partnerships
Overview
Individual: Sarah, a sole trader, and Paul, a partner in a small business partnership.
Business: Sarah runs a graphic design business, and Paul is in a partnership running a small manufacturing firm.
Asset: Both Sarah and Paul own assets related to their businesses that have appreciated in value:
- Sarah’s Asset: A commercial property used for her business.
- Paul’s Asset: Shares in the partnership.
Objective: Sarah and Paul both want to sell their respective assets and extract the capital gains in a tax-efficient manner.
Scenario 1: Sarah (Sole Trader) - Sale of Commercial Property
Background:
- Purchase Price: £150,000
- Current Market Value: £300,000
- Capital Gain: £150,000
- Tax Year: 2023/24
- Annual CGT Allowance: £6,000 (for 2023/24).
Step 1: Calculate the Capital Gain
- Total Capital Gain:
- Sale Price: £300,000
- Purchase Price: £150,000
- Capital Gain: £300,000 – £150,000 = £150,000
- Apply CGT Allowance:
- Taxable Gain: £150,000 – £6,000 = £144,000
Step 2: Determine the CGT Rate
CGT Rates for Individuals:
- 10% for basic rate taxpayers.
- 20% for higher rate taxpayers (on most assets).
Sarah’s Income:
- Assume Sarah has an income of £30,000 from her business, which falls into the basic rate tax band.
- Adding the taxable capital gain of £144,000 will push her into the higher rate tax band.
Step 3: Calculate the CGT Payable
Basic Rate Band:
- Basic rate threshold for 2023/24 is £50,270.
- £50,270 – £30,000 (income) = £20,270 (remaining in the basic rate band).
- CGT on £20,270 at 10%: £20,270 * 10% = £2,027.
Higher Rate Band:
- Remaining gain: £144,000 – £20,270 = £123,730.
- CGT on £123,730 at 20%: £123,730 * 20% = £24,746.
Total CGT Payable:
- Total CGT: £2,027 + £24,746 = £26,773.
Step 4: Exploring Tax-Efficient Options
- Roll-over Relief:
- If Sarah reinvests the proceeds into another qualifying business asset (e.g., another commercial property), she can defer the CGT. The gain is “rolled over” into the new asset, delaying the tax liability until the new asset is sold.
- This is particularly useful if Sarah plans to continue growing her business.
- Entrepreneurs’ Relief (Business Asset Disposal Relief):
- If the property qualifies as a business asset, Sarah could potentially reduce the CGT rate to 10% on the gain.
- CGT Payable with Entrepreneurs’ Relief: £144,000 * 10% = £14,400.
- This represents significant savings compared to the standard CGT rate.
- Timing of Sale:
- If Sarah anticipates a lower income in a future tax year (e.g., due to reduced business activity), she might delay the sale to benefit from a lower tax band.
Scenario 2: Paul (Partnership) - Sale of Partnership Shares
Background:
- Paul’s Share of Partnership: 50%
- Initial Value of Paul’s Share: £100,000
- Current Value of Paul’s Share: £250,000
- Capital Gain: £150,000
- Tax Year: 2023/24
- Annual CGT Allowance: £6,000 (for 2023/24).
Step 1: Calculate the Capital Gain
Total Capital Gain:
- Sale Price: £250,000
- Purchase Price: £100,000
- Capital Gain: £250,000 – £100,000 = £150,000
Apply CGT Allowance:
- Taxable Gain: £150,000 – £6,000 = £144,000
Step 2: Determine the CGT Rate
CGT Rates for Individuals:
- 10% for basic rate taxpayers.
- 20% for higher rate taxpayers (on most assets).
Paul’s Income:
- Assume Paul’s income from the partnership is £40,000.
- Adding the taxable capital gain of £144,000 will push him into the higher rate tax band.
Step 3: Calculate the CGT Payable
Basic Rate Band:
- Basic rate threshold for 2023/24 is £50,270.
- £50,270 – £40,000 (income) = £10,270 (remaining in the basic rate band).
- CGT on £10,270 at 10%: £10,270 * 10% = £1,027.
Higher Rate Band:
- Remaining gain: £144,000 – £10,270 = £133,730.
- CGT on £133,730 at 20%: £133,730 * 20% = £26,746.
Total CGT Payable:
- Total CGT: £1,027 + £26,746 = £27,773.
Step 4: Exploring Tax-Efficient Options
Entrepreneurs’ Relief (Business Asset Disposal Relief):
- If Paul qualifies for Entrepreneurs’ Relief, the CGT rate on the gain could be reduced to 10%.
- CGT Payable with Entrepreneurs’ Relief: £144,000 * 10% = £14,400.
- This could reduce Paul’s CGT liability significantly.
Holdover Relief:
- If Paul gifts his share in the partnership to a family member or into a trust, Holdover Relief could allow the CGT to be deferred. The recipient would inherit the original base cost, and the tax would only become payable when they sell the asset.
- This is useful for succession planning.
Incorporation Relief:
- If Paul and his partner decide to incorporate the partnership into a limited company, the gain could be deferred by transferring the business assets into the new company. The gain is effectively “rolled over” into the shares in the new company.
Timing of Sale:
- Similar to Sarah, Paul could time the sale to coincide with a year where his income is lower, ensuring that a larger portion of the gain falls within the basic rate band, thus minimizing the CGT.
Conclusion
Both Sarah and Paul have opportunities to extract capital gains from their respective businesses in a tax-efficient manner. By leveraging tax reliefs such as Entrepreneurs’ Relief and timing their sales strategically, they can significantly reduce their CGT liabilities.
- For Sarah: If the property qualifies, claiming Entrepreneurs’ Relief and paying CGT at 10% would result in a tax bill of £14,400 instead of £26,773, saving £12,373.
- For Paul: By using Entrepreneurs’ Relief, Paul could also reduce his CGT liability to £14,400 from £27,773, saving £13,373.
These strategies underscore the importance of understanding and utilizing available tax reliefs and considering the timing of asset sales to achieve maximum tax efficiency.