Case study brief
Campbell Edgar CFPTM Chartered FCSI
Campbell is Head of Financial Planning at the CISI. Until 2014 he was Head of Private Clients at John Lamb, a financial planning firm based in Southwark, London. This is a real life case study. Names and some other details have been changed to protect confidentiality.
Derek Jones had been referred to me by an existing client as they both served on the same parish council of their local church in Sussex. Derek had just turned 65 and was planning to run down his engineering consultancy over the next few years and then finally retire. The consultancy was structured as a limited company, with 80% of the shares owned equally between Derek and his wife Susan, who is five years younger than him, with their two children holding 10% each. Susan was the secretary of the firm, but was mostly occupied with teaching part-time at a local primary school. Their two children were both grown up and independent financially.
Initial financial planWhen Derek and I first met, his primary concern was to sort out the jumble of pension plans and arrangements he had managed to accumulate over a working life of 40 years or so. Over the next four months we were able to construct an initial financial plan together, as well as involving his accountant and solicitor, which covered off many other aspects of Derek and Susan’s lives.
Derek paid himself and Susan a small salary below the National Insurance threshold, topped up with a dividend designed to keep them just below the higher rate tax threshold. The children received their dividends pari passu.
It transpired that with a joint net worth of £2m, excluding their home, and a relatively modest lifestyle, Derek and Susan were effectively financially independent already. This meant that the plan incorporated not just a pensions consolidation exercise, but also a strategy for giving away assets to children and charities, in conjunction with an investment strategy for the pensions, individual savings accounts (ISAs) and other investment holdings that had been acquired over time.
Locating assetsThe biggest problem for Derek and Susan, however, was not so much asset allocation as asset location, because the bulk of their wealth was in the limited company. The company held cash balances and deposits (in sterling and euros) of some £540,000, and a property in London estimated to be worth £750,000. The cash was held in the company as undistributed profit while the property was bought by the company some years ago (in April 2005 for £330,000) and used for company business since. It had appreciated significantly in value, so any disposal would give rise to a significant tax bill. According to the accounts filed at Companies House, the cumulative profit and loss balance was just under £900,000 (which could rise when the company sold the property).
The financial plan therefore looked first at strategies to extract value from the company in the most tax efficient way, as well as other financial planning aspects which were affected by the winding up of the business. In principle, it was reasonably straightforward to collect remaining debts, pay off outstanding creditors and wind up the company. In practice, however, this could have been quite expensive and could have left Derek and Susan open to a number of tax and other challenges. Many of these were handled perfectly well following advice from their accountant, but there were one or two extra strategies that Derek and Susan could use to their advantage.
The biggest problem was not so much asset allocation but asset locationWhen owner-shareholders want to extract the assets they own within the company, they discover that while they have enjoyed reasonably favourable tax breaks up to that moment, HM Revenue & Customs (HMRC) will tax assets moved from corporate to personal ownership. The normal first step in the winding up of a company is to sell the company’s assets to third parties, which may create a corporation tax (CT) liability which would need to be paid. In the year of cessation, a final dividend distribution of up to £25,000 can be made, which is treated as capital gains, and so uses the owners’ CGT allowances. Any further distribution is then taxable. To mitigate this, the company could vote to go into voluntary liquidation, whereby the assets would be distributed in line with the shareholders’ rights. Based upon the Articles of Association, this was 40% each to Derek and Susan, and 10% to each child.
The difficulty with this approach was the large profit arising on the disposal of the London property. A gain of £400,000 plus would have given rise to a CT charge of the order of £100,000, unless losses could be created elsewhere. This is where it was possible to use current pensions legislation to the couple’s advantage.
Contributions by the company to pension schemes for its directors and employees are a revenue expense allowable for CT purposes, do not attract a benefit in kind charge and are not subject to National Insurance contributions. What this means is that pension contributions could be used to offset the profits on the sale of the property. Under the then current pension regime, the annual contribution maximum allowance was £50,000 (it is now £40,000). It was also possible to pick up any unused contribution allowance in the previous four years, as they already each had a pension in place in those years. In theory, the company could have contributed over £200,000 each to Derek and Susan’s pensions, and offset the gains on the sale of the property in the same financial year, if that is what they wanted. HMRC would most likely have challenged this and attempted to disallow the pension contributions as a revenue expense. If the pension contributions were spread over a number of years, however, this was much less likely to happen.
Derek made it clear that he did not wish to retire yet, but preferred to wind up the business over the next few (we planned on five) years and did not wish to sell the London property yet. Because the company had accumulated profits rather than distributed them, it could continue to pay dividends to the shareholders, even if the company was making trading losses. The trading losses arising through large (but reasonable) pension contributions could be carried forward indefinitely and then be used to offset against the profit on the sale of the property when it is eventually sold.
The recommendation was that the company make annual pension contributions on behalf of its employees (Derek and Susan) of the order of £40,000 each for the next five years.
In this way Derek and Susan would have:
- transferred the large cash balances out of the company into their pensions without incurring tax
- created trading losses (provided the revenue to the company reduces as Derek anticipated) to offset gains made on the property sale
- improved both Derek and Susan’s pension provision, with the attendant benefits and issues, which were covered in more detail elsewhere in the plan
- prepared the company for an orderly voluntary liquidation with a significantly reduced tax exposure, while still providing some extra benefit for their children.
What happened next?
Once the strategy was validated by their accountant, the director (Derek) and secretary (Susan) minuted the resolution to make company contributions to pensions and the first contributions were duly made. A trading loss for that financial year was carried forward against future losses. The strategy continues to be played out.
Takeaways:
1. Clients’ initial objectives are easy to sort out. It’s the hidden problems that need to be teased out.
2. Be an expert in your field. Understand pensions, corporate taxation and their interaction.
3. Think strategy, not tactics.
The original version of this article was published in the July 2016 print edition of The Review.