You’re closing your company as it’s barely covering its costs. You’ve been told that the company can pay you a tax-free termination payment. Is this right and how will it affect the company’s tax position?
What’s a termination payment worth?
You might have read or been told that the most tax-efficient method of getting the money out of your company when it closes down is to wind it up and take its cash and other assets. That way the maximum rate of tax on what you receive is 10%, assuming that capital gains tax (CGT) entrepreneurs’ relief (ER) applies. (Note that ER is now called business asset disposal relief; BADR). This is true but it overlooks what you might be entitled to receive entirely tax free.
Director’s redundancy payments
As a director you may be entitled to statutory redundancy pay when you close your company. This is a tricky point but essentially if you’ve worked in the company’s business, i.e. done more than just carry out your duties as a director required by company law, and if you have an employment contract, you have the same rights as any other employee. If you’re winding up your company you’ll get all its money and assets anyway (or your share of it if there are other shareholders), so you might think that giving yourself a redundancy pay off isn’t worth the effort. You’d be wrong.
Example. John has owned all the shares in Acom Ltd for more than 20 years. If it permanently ceases to trade and John meets the conditions for redundancy pay, Acom can pay him the maximum, which for the purposes of this example we’ll say is £16,140. This reduces the money Acom has to pay him when it’s wound up. On the other hand, Acom is entitled to corporation tax (CT) relief for the payment which increases its funds by £4,374 (£16,140 x 19%). This extra money goes to John on which he pays tax at 10% (the BADR rate). That makes him £3,937 better off. Plus, because he doesn’t have to pay tax on the redundancy pay it saves him another £1,614 (£16,140 x 10%) being the CGT he would have paid on the £16,140 had the redundancy payment not been made.
Tip. If John’s employment contract entitled him to an additional payment for redundancy the CT and CGT savings would be greater. The rules allow a CT deduction for an additional payment of up to three times the statutory redundancy amount. However, to the extent that the total of statutory and non-statutory payments exceeds £30,000 they are less tax efficient than taking the money as proceeds from the winding up of the company.
Trap. Contractual redundancy pay for directors is often attacked by HMRC which argues that it doesn’t qualify for a CT deduction and that the payment is really for the director’s shares and so liable to CGT.
Tip. The longer an employment contract is in place the less likely it is that HMRC will attack the related redundancy payment.
Planning a wind up
Creating a relatively last-minute contract of employment to secure entitlement to a redundancy payment is likely to be attacked by HMRC. Therefore, if you want to take advantage of the tax breaks that go with redundancy pay the best policy, especially for one-man companies, is to create an employment contract early in your company’s life.
Director shareholders are entitled to redundancy pay if they are paid employees of the company. It’s tax free up to £30,000. Special rules mean that the company is entitled to a tax deduction for this. Redundancy pay saves tax compared with taking the money as proceeds from winding up, for example up to £5,500 for a payment of £16,000.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.