Succession planning initiatives for family businesses can be significantly impeded if the tax implications of the preferred courses of action are not taken into account by the owner.
The tax treatment of the various options available to the owner can make a huge difference to the final sum they get, and to the total cost to any purchaser. If this barrier can be removed, or properly managed, the family members can devote their energies to all of the other relevant business issues.
Concessions to reduce or eliminate the Capital Gains Tax (CGT)
While there are many tax considerations, including stamp duty and GST, one of the most significant costs can be CGT on the transfer of the business. There are several important concessions that can be accessed to reduce or eliminate the CGT.
These concessions can be particularly important when transferring the business to the next generation, making it easier for the owners to exit the business and plan their retirement.
For example, some or all of the following CGT concessions may be available which can help when transferring the shares in a family business company to members of the next generation:
Pre-CGT shares – where the current shareholders of a family business company acquired their shares before 19 September 1985 (i.e. pre-CGT), there should be no CGT on transferring these shares. Less than 75 per cent of the value of the company must be represented by assets that the company acquired post-CGT (including the value of goodwill where the business commenced after September 1985) for this to apply.
50 per cent CGT discount – where the shares are post-CGT, and have been held for at least twelve months, then the general CGT discount allows individuals and trusts a 50 per cent reduction in the taxable capital gain on transfer of the shares. For an individual on the top marginal tax rate of 48.5 per cent, this represents an effective tax rate of 24.25 per cent on the capital gain.
Small business active asset reduction – where the shareholder (and any associates) owns total net assets of less than $5 million (excluding their home and superannuation fund), at least 80 per cent of the company’s value is represented by active business assets (as opposed to passive investment assets), and the shareholder or their spouse is a controlling individual, this concession may be available. If so, CGT will be reduced still further. A “controlling individual” is one that is entitled to receive at least 50 per cent of any income and capital distributions and has at least 50 per cent of the voting rights.
Where the required conditions are met, the taxable capital gain on sale of the shares will be reduced by a further 50 per cent, so that only 25 per cent of the gain is taxable and the maximum effective tax rate on the capital gain will be 12.125 per cent. This concession can often be combined with the small business retirement concession (eliminating CGT completely) or with the small business replacement asset rollover (deferring the tax).
Small business retirement exemption – this concession is subject to a lifetime limit for each person of $500,000. It is especially useful if the individual is over 55 and retiring, as (apart from the $500,000 limit) there are no restrictions. For people under 55, the exempt portion (i.e. 25 per cent of the total capital gain) must be paid into a complying superannuation fund and held by the fund until their retirement.
Small business active asset rollover – This concession is an alternative to the retirement exemption, and may be useful where the shareholder plans to invest the proceeds of the shares into another business (as shares in a business company, as a controlling individual, or directly into business assets).
It allows the remaining capital gain (after applying available concessions as discussed above) to be rolled over and not taxed until the sale of the replacement asset. The retirement exemption is, however, more likely to be used for succession planning.
Share buy-back
As an alternative to a transfer of the shares in a family business company to members of the younger generation, the company itself may consider buying back the shares at market value in certain circumstances. A portion of the share buy-back proceeds is usually payable as a dividend, franked to the extent that the company has franking credits available.
A share buy-back including a large franked dividend can provide a similar result to the 50 per cent CGT discount on a share sale, as the maximum effective tax rate on a franked dividend is 26.43 per cent compared to 24.25 per cent for a share sale. The position is even more favourable for shareholders on a lower marginal tax rate, eg at a personal tax rate of 30 per cent no additional tax is paid on a franked dividend, compared to 15.75 per cent on a share sale using the CGT discount.