How to reduce Capital Gains Tax on selling your small business
19 Sep 2014
By Shadforth Financial Group
There are significant small business Capital Gains Tax (CGT) concessions on selling a small business that can help you eliminate or substantially reduce tax upon the disposal of business assets. Despite the great benefits that apply to small businesses, they are often referred to as the most complex piece of tax legislation to apply in practice. The volume of recent case law surrounding these rules highlights the fact that their application are subject to strict ATO scrutiny. Importantly, for owners and advisers, the risk of applying the rules incorrectly can be enormous, therefore, the involvement of an experienced tax practitioner in this field is imperative to achieving the best result.
For many small business owners, their business represents a major percentage of their overall wealth. On most occasions, the owner's retirement will be financed by the sale of their business. Where CGT is payable on the sale of the business assets, this will directly affect the owner's cash position upon retirement. Therefore, "sound" taxation advice is required both upon entry into the business structure and upon exit.
A range of small business CGT concessions may be available when a small business is sold. They include:
- Small business 15-year exemption - broadly, where business assets have been held for 15 years or more and individuals involved in operating the business are 55 years or over and are retiring or permanently incapacitated, then this concession may apply to reduce the capital gain made on the sale of business assets to nil (subject to all other conditions being satisfied). That is, no tax would be payable on the capital gain;
- Small business 50% reduction - any net capital gain may be reduced by 50%;
- Small business retirement exemption - this provides a lifetime exemption of $500,000 per "significant individual" as defined on page 10.
- Small business roll-over - this provides an ability to reduce and defer the capital gain to nil where the owner/seller uses the capital proceeds to acquire a replacement business asset.
These concessions have the ability to reduce CGT to nil, on the sale of a business (or business related assets). However, to apply these concessions, intricate and complex rules need to be satisfied. Ultimately, how the rules apply will depend on the legal structure used to carry on the business. Unless "thought" is given to the implementation of the most appropriate legal structure (i.e. with regard to the future sale of the business), the owners may miss out on applying these concessions.
Broadly speaking, where an owner disposes of a business (or business related assets) and derives a capital gain, the following basic conditions must be satisfied in order to consider applying the small business CGT concessions:
- Maximum net asset value test - this test requires that the net assets of the owner/seller together with its "connected entities" and "affiliates" be no more than $6 million. "Connected entities" and "affiliates" are all defined terms. Assets that do not form part of this net asset value test include; principal place of residence, superannuation and assets held for private use.
- "Small business entity test" - an owner/seller who does not satisfy the $6 million test can still qualify if the owner/ seller is a "small business entity". Broadly speaking, an owner/seller (or a "connected entity" or "affiliate") must carry on a business with an annual turnover of less than $2 million. This test is often useful for land held by primary producers (i.e. where land may be valued at greater than $6 million but the primary producers turnover is less than $2 million).
- "Active asset test" - this test requires that the assets disposed of must be "active assets". This includes assets used in conducting a business such as goodwill, other non-depreciable intellectual property and land and buildings. Also, the asset will need to have been an active asset for at least half the period of its ownership up to a maximum of 7.5 years where the asset has been held for more than 15 years.
In addition to the above, where owners of a business dispose of shares in the operating company or interests in an operating trust (rather than the business operating assets), further onerous and complex conditions are required to be met in order to apply the small business CGT concessions. In general this includes:
- "Significant individual test" - this test requires that the company or trust, in which interest are being disposed of, must have at least one "significant individual". This is defined as being an individual with a "small business participation percentage" in the company or trust of at least 20%. For example, in relation to a company the "small business participation percentage" refers to the individual shareholders percentage ownership (having regard to voting, dividend and capital rights). The application of this test becomes extremely complex where multi-tiered structures are in place.
- Application of the "active asset test" - shares in a company or interests in a trust will be "active assets" where at least 80% of the market value of the entity consists of "active assets". This requires an analysis of the underlying balance sheet of the business operating entity, on a market value basis, to determine whether the equity interest are "active assets".
Notwithstanding the above complexity, when applying each of the specific small business CGT concessions, further rules are required to be met.
The rules governing the small business CGT concessions have changed on numerous occasions since originally being introduced on 21 September 1999 (and will most likely change in the future). As a result, businesses that were originally structured with the concessions in mind, may find they no longer qualify for them. An example of this is where appreciating assets (such as land and buildings) are held by a passive holding trust whilst the business is carried on by a separate trading trust.
Prior to the change in the definition of "affiliate", such an arrangement may have been appropriate in applying the concessions (on the basis that both trusts were acting in "concert with" each other) where the land and buildings were sold. However, the current definition of "affiliate" does not specifically refer to a trust estate. Therefore, under the current drafting of the rules, both trusts may need to be "connected with" each other (which requires a common 40% control test to be satisfied).
When owners are commencing or purchasing a business, one of the most important decisions is to adopt an appropriate business structure. Due consideration must be given towards the ability to gain access to the small business CGT concessions as part of the structuring process and the owner's exit plan.
Accordingly, for business owners, it is imperative to obtain expert advice when setting up business structures and when exiting a business. Importantly, the cost of applying the small business CGT concessions incorrectly can be enormous, that is paying tax on the entire capital gain vis-à-vis paying nil tax.