Most business owners (limited companies with 1-4 directors) are unaware that surplus cash in their company is subject to a punitive 40% tax charge. This is caused by inadvertently ‘Trading Places’.
Two thoughts should immediately spring to mind; Firstly, why and how is this so, and secondly what is the definition of surplus cash? This brief insight should help to answer these points.
The tax is due because the starting point for HMRC is that company cash is an asset and therefore tax is due on it. There is however relief available which can reduce the tax from 40% to 0% if the business owner can show that the amount of cash held is reasonable and just in relation to the trade of the company. For example, a small business that was in the trade of selling trophies and awards would have little requirement for a cash balance of £100,000 that could have been built up from successful sales over 10 years. In this example, the cash would undoubtedly be subject to a 40% charge. In contrast, a small development company that buys and sells parcels of land would have justification for a cash balance of £100,000 due to the value of the assets that is trades.
In these examples, the use of the word trade cannot be undermined because it is this word which is key to determining how HMRC could tax your company. If your company is similar to the first example of the trophy company then HMRC will treat the business as being an investment company, because cash is, in the eyes of the tax inspector, a form of investment. When a small business is treated as an investment company, it loses entitlement to relief of tax on cash balances. In the second example, the small business involved in the trade of land purchases and sales would most likely be able to claim relief of tax on the cash balance. This is because it is deemed to be a trading company.
From a technical perspective, the shares in your company are made up of the value of all the company assets, goodwill and of course cash held on account. The relief is known as Business Property Relief (BPR) and it is applied – or possibly not if HMRC decline the relief – to shares in your small enterprise. BPR can be claimed where your company is a genuine trading company and not an investment company, so for some businesses such as those that own buy to let property, relief can never be sought because the company is already an investment company.
A further question arises, which is at what point does the cash balance held on account cause your trading company to become an investment company. The answer is generally found by applying a series of 20% tests, which unfortunately but unexpectedly fall in favour of HMRC. The tests are whether the cash represents more than 20% of the balance sheet, or more than 20% of the turnover or even the profit. HMRC have been known to win first tier tax tribunals as a result of the directors investing more than 20% of their time managing investments. An example of this could be where a director has a share dealing account and spends much of their time managing this rather than focussing on the trade of the company.
A problem exists but thankfully there is an answer. A Lifetime Business Tax Plan can be set up and company cash can be moved into the bank account linked to the plan. The shareholders of the original trading company (that may have inadvertently become an investment company) remain in full control of all the cash but the cash is effectively held on trust for the benefit of their family. This simple plan removes the tax charge in its entirety and allows the beneficiaries to receive the full cash balance. The cash can be invested within the plan in any asset class from property to shares and tax is only applied to the gains made through the investments, not the actual cash held. Most importantly, the grey area of whether the company has become an investment company or not is no longer a point for contention and BPR can claimed on the company share value.
A Lifetime Business Tax plan is made up of two components; a business trust fund and a small self-administered scheme (SSAS) both of which are only available to company directors. These exclusive tax mitigation plans also allow directors to transfer in former work pensions that are frozen or unmanaged. The transfer of company cash and former pension cash into one plan can create significant liquidity, thereby providing wide investment choice in a low to zero tax plan.
If you are concerned that your trading company may have ‘traded places’ and become an investment company, putting your company cash at risk of a 40% charge then do get in touch for a free review of your circumstances. Since 2004 we have successfully helped 1000s of clients with financial plans, the majority of which have rated our service as 5-star. We are registered with HMRC as trust and company formation providers and also as pension administrators.