IT contractor closing down a limited company

I am an IT contractor and have been trading through my limited company for eight years. I am the sole director and shareholder. I have been offered a role as a full time employee which I am going to accept.

I don’t see the need to keep my company open, as I don’t expect to come back to contracting, so I want to close the company down. I have built up a sizeable cash pile in the company over the years and anticipate this will total £100,000 once all tax and liabilities have been settled.

Will I be able to extract the final amount of money as a capital distribution or will it be treated as dividend income?

IT contractor closing down limited company

Answer, September 2016, based on 2016/17 tax year

When it comes to final cash extractions from a limited company, depending on the circumstances, these will either be treated as dividend income or as a capital distribution subject to capital gains tax.

If the final amount of funds are £25,000 or less, then they are automatically treated as a capital distribution under tax law (this used to be called Extra Statutory Concession C16).

If the funds are over £25,000, then in order to be treated as capital they will need to be distributed in a formal liquidation process, often called a members voluntary liquidation, without this formal process the distribution will be taxed as dividend income.

Normally capital distributions would be taxed under the standard capital gains tax rates, but there is an exception called entrepreneurs relief, which means the capital gains are taxed at a lower rate of 10%.

This makes it very attractive compared to being taxed as a dividend, especially with the higher dividend tax rates which have come in from 2016/17.

In order to qualify for entrepreneurs relief there are certain criteria which must have been met for at least a year, including:

  • The company must be a trading company (not an investment company)
  • You personally must have at least 5% of the ordinary share capital and voting rights
  • You must be an officer or employee of the company

Going back to the question at hand, an IT contractor who is the sole director and shareholder and has been trading for several years appears to be likely to meet the criteria in order to be able to claim entrepreneurs relief on a capital distribution.

 

Additional new rules from 6th April 2016

However, we have one further complication – distributions from 6th April 2016 are now also subject to additional new ‘targeted anti-avoidance rules’ around ‘distributions on a winding up’.

This new set of rules was brought in to target situations where a winding up was being done for tax saving purposes rather than for non-tax reasons.

Under these new rules a distribution will be treated as income, not capital, if all of the below conditions are met:

  • The individual holds at least 5% ordinary share capital and voting rights in the company
  • The company is a close company
  • The individual carries on the same or similar trade within two years from the date of distribution
  • The main purpose of the distribution is to obtain a tax advantage

Going back to the question at hand, as the IT contractor wishes to close down their limited company because they have been offered a full time job, the purpose of the distribution does not seem to be for a tax advantage, but purely for a commercial reason, therefore they do not appear to be caught by the new targeted anti-avoidance rules.

An issue could arise should the contractor leave the new employment and start contracting again within two years as HMRC could then challenge the original distribution under the new anti-avoidance rules – they would have to then demonstrate to HMRC that the distribution was not primarily for tax purposes, which can be hard to prove.

Assuming the new anti avoidance rules do not affect the example at hand, as the final amount of distribution is more than £25,000 then in order for the funds to be treated as capital an official liquidation process will need to be followed (usually a members voluntary liquidation), otherwise the final funds will be treated as income.

If the distribution was taxed as capital, and was eligible for entrepreneurs relief, the tax charge would be as below (based on 2016/17 tax rates):

 

capital gain

 

From this you would need to take into account the fees paid to an insolvency practitioner to perform the official members voluntary liquidation (likely to be in the region of £2k – £4k – we can recommend MVL Online).

If, instead, the funds were extracted as income, it would be £100,000 of dividends taxed at the relevant rates.

Assuming the tax payer is already in the higher tax band this will be at least 32.5% (so £32,500 of tax) but in reality it could be even higher than this because:

Overall it is clear that a capital distribution would be preferable for this example, but care needs to be taken to consult a professional advisor (ideally an experienced accountant for contractors) who can ensure all the conditions are met both for a capital distribution and also to ensure eligibility for entrepreneurs relief – there are a lot of pitfalls with this topic and this article is intended as introductory general advice only.