The small business capital gains tax (CGT) concessions can provide major tax savings when selling a business if all the relevant requirements can be met.
One of the most common questions that comes up in these situations is whether a share sale or asset sale will give the business owners the best after tax outcome.
There are of course many commercial, legal and practical considerations, but this article will focus on the main issues impacting the tax payable from the sale. If one approach offers a sufficiently large tax saving over another, there will be an incentive to find ways to overcome any of the other barriers that may exist. It may be, for example, that it is worth offering a discount on the price or other concessions on the commercial terms of the sale to achieve a tax saving.
Set out below is a discussion of some common situations that arise in practice, and the factors influencing the choice between a share sale and an asset sale from a tax perspective.
Situation 1 – Individuals aged over 55, business operating for less than 15 years
Key facts
- Lucy (age 56) and Ian (age 57) run a business through Better Productions Pty Limited.
- All of the shares are owned by the Better Discretionary Trust.
- The business commenced operations 10 years ago.
- The net value of the business is $4m comprising current assets of $300,000, plant and equipment with a WDV of $200,000, current liabilities of $100,000 and $3.6m of goodwill.
- Lucy and Ian will each receive at least 20% of the Trust’s income in the year of sale.
- Lucy and Ian both have a marginal tax rate of 47% (including Medicare Levy).
- All other relevant criteria for applying the small business CGT concessions are met.
Share sale
- The Trust would make a $4m gross capital gain on selling its shares in Better Productions.
- As the shares have been held for more than 12 months, the 50% CGT discount would apply, reducing the Trust’s capital gain to $2m.
- Further, the active asset concession can be applied to reduce the Trust’s capital gain to $1m.
- Finally, both Lucy and Ian qualify as “CGT concession stakeholders” as their indirect interest in Better Productions is at least 20%.
- This means that they can apply the retirement exemption, each claiming their full $500,000 lifetime limits, reducing the Trust’s taxable capital gain to Nil.
- As they are aged over 55, no retirement exemption amount must be paid into a super fund, although Lucy and Ian can still do so if they wish to build up their super balance.
Asset sale
- Better Productions would transfer its plant and equipment for WDV of $200,000, resulting in no taxable gain on these items.
- The company would also presumably retain its current assets and liabilities.
- The company would make a gross capital gain of $3.6m on selling its goodwill and would not be eligible for the CGT discount.
- The company could claim the active asset concession, i.e. to reduce the company’s capital gain by 50% to $1.8m. This is merely a deferral, however, as the tax-free portion of $1.8m would ultimately be taxed on distribution to the shareholders as an unfranked dividend, so in certain cases it can be worth “skipping” this concession.
- Lucy and Ian can each claim their full $500,000 entitlement under the retirement exemption, reducing the company’s taxable capital gain by a further $1m to $800,000.
- The active asset rollover concession may be applied to the $800,000 taxable gain, but it merely offers a 2 year deferral of the company’s tax liability, unless this amount is actually reinvested into a replacement active asset, e.g. if the company buys another business.
- As noted above, in this case the retirement exemption can be applied without making any payments to a super fund, although Lucy and Ian can choose to do so.
- The best case here is net tax payable by Better Productions of $220,000 (i.e. $800,000 x 27.5%), which could later be used to pay franked dividends from the after tax profit.
- Before claiming franking credits and ignoring the possible effect of future changes in the company tax rate, the total amount that would be ultimately taxed to the shareholders at their marginal tax rates would be $2.6m, with potential for tax leakage as high as $1.2m.
The verdict
- A share sale is clearly much more tax effective in this situation.
Situation 2 – Individuals aged in their 40’s, business operating for less than 15 years
Key facts
- As for situation 1, except Lucy is aged 46) and Ian is aged 47.
Share sale
- As for situation 1, except that the $1m retirement exemption amount must be paid into a super fund on behalf of Lucy and Ian because they are both aged under 55.
Asset sale
- As for situation 1, except that the $1m retirement exemption amount must be paid into a super fund on behalf of Lucy and Ian because they are both aged under 55.
The verdict
- A share sale is still likely to be much more tax effective in this situation.
- The main proviso is that, if Lucy and Ian are reluctant to pay $1m into a super fund and did not therefore choose to utilise the retirement exemption, they could seek to defer paying tax on the $1m indefinitely under a share sale if they plan to invest at least that amount into a replacement active asset such as buying an existing company.
- Similarly, under an asset sale if they chose not to apply the retirement exemption then tax on the $1.8m gain could be deferred indefinitely as long as they have the company invest at least that amount into a replacement active asset such as buying another business.
Situation 3 – Individuals aged over 55 and retiring, business operating for 15 years
Key facts
- As for situation 1, except that the company has been carrying on the business for 15 years.
- You have also been advised that Lucy and Ian are both retiring and will have no ongoing role with the business following the sale.
Share sale
- As the Trust has owned the shares for at least 15 years, the shares satisfy the “active asset test” and the sale is “in connection with” the retirement of either Lucy or Ian, then the sale should be completely tax-free under the 15 year exemption.
- If any of the shares had been held for less than 15 years, even though the business has been carried on for 15 years, the exemption would not generally be available for those shares.
Asset sale
- As the company has carried on the business for 15 years, and the sale is “in connection with” the retirement of either Lucy or Ian, then the sale should be completely tax-free in the hands of the company under the 15 year exemption.
- Under this exemption, the company can also make tax-free payments to both Lucy and Ian in their capacity as beneficiaries of the Trust, making the entire transaction tax-free for them.
The verdict
- In this situation either approach will be completely tax-free, so Lucy and Ian can choose the option that is most effective and easiest to achieve commercially.
- If there had been changes in the shareholding so that not all shares had been held for 15 years, an asset sale may provide opportunities to receive all or at least a greater proportion of the total sale proceeds free, giving it an edge over a share sale in those cases.
Situation 4 – Individuals aged over 55, one person retiring, business operating for 15 years
Key facts
- As for situation 3, except that Lucy enters into an ongoing arrangement with the purchaser to work in the business for the next 2 years, helping to transition key clients, progress the development of current projects, pursuing growth opportunities and integrating the business into the existing business carried on by the purchasing entity.
- While Lucy has been the driving force behind, and the “face” of, the business over the last few years, Ian’s role has been that of part-time office manager.
- Following the sale Lucy is expected to devote around 25 – 30 hours to the business, winding back slightly towards the end of the 2 year period, while Ian will retire completely.
Share sale
- As for situation 3, on the understanding that Ian qualifies as a “significant individual” of the company and the Trust through receiving at least 20% of distributions from the Trust in the year of the sale, and Lucy is Ian’s spouse as well as receiving at least some distribution from the Trust in the year of sale (even if it is not as high as 20%).
- While the 2 year arrangement with the purchaser means that the sale is unlikely to be treated as occurring “in connection with” Lucy’s retirement, it is reasonable to suggest that the sale can be treated as occurring “in connection with” Ian’s retirement.
- The entire sale should therefore be tax-free under the 15 year exemption.
Asset sale
- As for situation 3, on the understanding that Ian qualifies as a “significant individual” of the company and the Trust through receiving at least 20% of distributions from the Trust in the year of the sale, and Lucy is Ian’s spouse as well as receiving at least some distribution from the Trust in the year of sale (even if it is not as high as 20%).
- While the 2 year arrangement with the purchaser means that the sale is unlikely to be treated as occurring “in connection with” Lucy’s retirement, it is reasonable to suggest that the sale can be treated as occurring “in connection with” Ian’s retirement.
- The entire sale should therefore be tax-free under the 15 year exemption.
- Under this exemption, the company can also make tax-free payments to both Lucy and Ian in their capacity as beneficiaries of the Trust, making the entire transaction tax-free for them.
The verdict
- In this situation either approach will be completely tax-free, so Lucy and Ian can choose the option that is most effective and easiest to achieve commercially.
- If there had been changes in the shareholding so that not all shares had been held for 15 years, an asset sale may provide opportunities to receive all or at least a greater proportion of the total sale proceeds free, giving it an edge over a share sale in those cases.
Conclusion
As discussed above, for the majority of closely held businesses it will be more tax-effective to sell shares rather than for a company to sell the business assets, subject of course to relevant commercial, legal and practical issues.
These situations generally allow the individuals behind the business, either directly or as beneficiaries of a trust, to use the CGT discount, the active asset concession and the retirement concession to significantly reduce or eliminate the CGT payable on a sale.
The most common situation where a business sale might be more tax-effective is for business structures that have been in place for 15 years or more and the relevant individuals are retiring from the business, especially where some shares have been held for 15 years and some shares have not.
