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Make capital, not income and watch your tax bill disappear

17th Jan 2011
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In the early Sixties, when the Beatles were young and England could play football, there was no such thing as Capital Gains Tax (CGT). If you made a capital gain, you paid no tax on it. Buy shares for £100 and sell for £150, and the £50 gain was yours, tax-free.

The party stopped in 1965 when the Government introduced CGT, initially at a rate of 30 per cent. Although this seems high today, income tax was over 40 per cent, so capital gains remained more favourably taxed than income.

The gap between income tax and CGT has fluctuated over the years and it is now at a record high (even with the recent increase in CGT rates).  The highest rate of income tax is 50 per cent plus National Insurance, compared with a maximum of 28 per cent for capital gains (for most entrepreneurs, the CGT rate will be much lower at 10 per cent). That is a colossal incentive for individuals to make capital, not income.

So how can entrepreneurs take advantage of this difference?

Money in a bank earns interest which can be taxed at as much as 50 per cent. Certain types of shares, on the other hand, are designed to create capital gains.  They don't pay an income but a set return which is classed as capital gains, which also qualifies for an annual capital gains exemption of around £10,000.

A husband and wife together could make capital gains of around £20,000 per annum tax-free.  As top-rate taxpayers, to get the same net return they would have to invest £1.6m in a bank paying 2.5 percent interest (£1.6m x 2.5 percent x 50 percent income tax = £20,000.)

With the current low interest rates and income tax five times higher than CGT for many, such investment vehicles are becoming increasingly popular as people seek to make a 'return' on their money.

For business owners the potential is even greater.  If a company makes a profit and pays a dividend, the owner will pay income tax on the dividend.  If the company keeps the profit and the owner sells the business with the profit still on the books, the owner makes a capital gain liable to CGT rather than top-rate income tax.  If a business owner qualifies for entrepreneurs relief the capital gains to income tax gap is even more extreme (CGT being only 10 per cent up to £5million of gain).

Before selling the business, an owner can draw money from the company by way of loans rather than receive a salary. There are tax implications with this course of action and professional advice should be taken, but it is likely to be much more tax-efficient.

There are also a number of more artificial, but completely legal ways to structure a business to release profits as capital rather than income, and accountants will be busy devising ever more ingenious structures as long as the disparity between capital and income tax treatments exists. 

Entrepreneurs and sole traders frequently aim to sell out for a large capital sum once the business is established, or to take early retirement. How much more satisfying to pay 10 percent on the money you receive, rather than slave for years only to find the Government taking more than half of all the money you draw.

Why not buy your own business yourself? Set up a company to buy the business from you and live off the capital gain (on which you’ve paid 10 percent tax or less). 

Perhaps, the time has now come to re-write Benjamin Franklin’s famous quotation: “In this world nothing can be said to be certain, except death...”           

Andy White
Partner
CBW
http://www.cbw.co.uk/staff-directory/andy-white
Part of the MGI Alliance
http://www.mgi-uk.com

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By Set up a Company
24th Jan 2011 10:36

Excellent

"Why not buy your own business yourself? Set up a company to buy the business from you and live off the capital gain (on which you’ve paid 10 percent tax or less). "

Excellent post Andy. I can see people doing this more and more in the current climate.

--

Smith Emmerson Chartered Accountants Nottingham

Set up a Company

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