How to buy out a colleague tax efficiently
Agreeing a buy-out
If you’re buying out a fellow director/shareholder, the last stage of the deal will be to find the cash to pay them. If you have the money sitting around you can simply sign on the dotted line and go ahead. But if you need to borrow, this might not be easy in the current economic climate and, what’s more, it can be costly in tax terms.
Paying for the shares
Assuming the bank is willing to advance you the cash, it will naturally expect repayment with interest. You might not be too worried because once the company is all yours you’ll be able to take more income to pay for this. But it will cost you a pretty penny even where you take the extra income as tax efficiently as possible, i.e. as dividends.
Example. Harry and Clare own equal shares in Acom Ltd. Harry borrows £100,000 to buy out Clare. The loan is over ten years and with interest will cost £1,215 per month. Because Harry pays higher rate tax he’ll need an extra £1,411 as dividends to meet the loan repayments. Over ten years this will cost £169,320. That’s £69,320 above the cost of the shares. Of this around £24,000 is extra tax. Clare will also have Capital Gains Tax (CGT) to pay of just under £9,000; a combined tax cost of £33,000 (see The next step).
Dividend funded buy-out
Instead, if Acom has cash and accumulated profits of £106,000 or more it could pay this as a dividend of £53,000 each to Harry and Clare. Assuming both are higher rate taxpayers they would lose a chunk of this in tax. They would both net about £46,000; Harry could use this, plus a small top-up, to buy the shares. Clare would end up with the same net amount as if Harry had paid her all in cash as in our example (see The next step). The good news is that the tax cost between them would total only £17,000, plus Harry wouldn’t have to borrow so he’ll save a small fortune in interest. But he could do even better.
Company funded buy-out
Tip. More tax can be saved if Acom uses its accumulated profits to pay Clare directly for her shares. After the deal this would leave Harry owning 100% of the company, i.e. in the same position he would have been had he bought the shares directly from Clare. This process is often called a company buy-back and it’s usually very tax efficient. In our example it would limit the tax cost to just under £9,000, i.e. the CGT for Clare. Harry doesn’t have to pay a penny in extra tax.
Trap. Because of the potentially large tax savings that can be made using company buy-backs, HMRC imposes strict conditions on when tax savings are allowed (see The next step). Among other things you’ll have to prove that the reason for the buy-back was commercial and not driven by tax savings.
Tip. Where there’s a dispute between director/shareholders which is damaging the company’s trade, and you can demonstrate this to HMRC, it will usually approve the tax-advantaged treatment.
For the calculations behind the examples (TX 13.19.03A) and for more information on share buy-backs (TX 13.19.03B), visit http://tipsandadvice-tax.co.uk/download.
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