Personal tax throughout the tech business lifecycle: a founders’ guide
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Aside from the tax compliance requirements tech businesses must fulfil, what should founders be thinking about in terms of their own personal tax positions? Our experts give their insights into personal tax considerations during the tech business lifecycle…
When starting up a new business, tech founders are often solely focused on ensuring its success. However, decisions made at the inception of a business can affect founders’ personal tax positions further down the line. As it is common for tech entrepreneurs to be serial entrepreneurs, it’s imperative for founders to consider their personal tax position at each stage of their tech business’ lifecycle, as well as ensuring they meet all other tax obligations.
“Entrepreneurs in other sectors tend to have a longer-term view of their businesses. For instance, aiming to establish a family business that they're setting up to pass down through the generations,” explains Montague.
“We don't tend to have tech entrepreneurs coming to us for a succession planning discussion - where they are looking to pass their business down within a family. The lifecycle of a tech business can generally be summarised as the formation, duration and exit stages. Then there is a need for private wealth structuring post-exit.”
Getting the right tax structure in place at the outset is often not high up on a founder’s list of priorities, but it can be hard to change later down the line. “They are likely focused on maximising the value of the company and may be dedicating their time to building the business and raising external funding,” Ebrahim notes. “Tax structuring is often not high up on the agenda.”
However, planning for founders’ own personal tax situation should be on the agenda early on, in order to maximise efficiency. “If structured in the right way, they should be able to obtain Entrepreneurs’ Relief (‘ER’) on a future exit from the business” says Montague.
If founders qualify for ER, they can get a preferential capital gains tax rate on exit.
Broadly, to qualify for ER the business must be an unquoted, trading company at the point of disposal of the shares. In addition, the founder must be working within the business, and have held more than 5% of the share capital for at least 24 months prior to an exit.
When launching their business, founders should be thinking about what their potential exit may look like and the outcomes they’d like to achieve. Qualifying for ER will be a part of that. In addition, “depending on how you set up the structure, there will be regulation and compliance to handle,” Montague explains. “For instance, if a founder sets up the business as a company at the outset, there's certain Companies House filing requirements, such as disclosing any people with significant control on a register. These filings need attending to along with their regular accounts and tax compliance filings.”
Founders may also need to consider beneficial owners register requirements. If the company is set up with the shares owned by a trust, there's also a trust registration which needs to be made if it is a UK business or the trust has a UK tax exposure.
"These beneficial owner registration requirements need to be complied with to ensure fines and penalties are not incurred."
Most external advisers appreciate that there is a cost benefit equation when founders are setting up their business; should they spend money up front to ensure everything has been set up correctly, or use that funding ensuring the business is viable first? If they have confidence there will be value in the business, it is worth spending the money to ensure they are getting the right advice. “It can be tempting to not spend on professional fees to reduce start-up costs, but getting the initial formation structure correct at the outset may end up saving the Founder much more down the line in tax or restructuring costs,” says Montague.
Where founders are non-UK domiciled, for instance where they have lived their entire lives outside of the UK and have recently arrived in the UK, the benefit of getting the structure right from the outset can make a material difference to their personal tax position.
During both the formation and duration stages, funding is a key factor to consider. If the funding is made by the shareholder, then a straightforward shareholder loan is usual practice. This would also allow the loan to be repaid in a tax neutral manner once the company is profitable.
Once a company turns profitable, the biggest question founders should ask themselves from a personal point of view is how to remunerate themselves.
"Founders are most likely also to be shareholders, and they will need to consider whether they wish to draw a salary from the business, or whether they can take dividends."
“There will be calculations that need to be done to determine what the most tax efficient route is, and what has the least impact on the business in terms of profit,” says Montague. “If they pay themselves a salary, the salary is going to impact the profit that the business is making. In contrast, when taking out a dividend, the dividend is not deducted from the profit - the profit element is calculated before the payment of dividends,” he explains.
Dividends and salary options also attract different rates of tax. Paying a salary might be more complicated because it requires the business to run a payroll; however, if there are other employees, this will be necessary anyway.
Another obligation to note is the yearly accounts and tax filings needed. “During the business’ operation, there will be annual tax filings on behalf of the company, but the founder shouldn’t forget to file his own Returns too. It’s important to be aware of both annual filing cycles and ensure returns are filed on time,” says Ebrahim.
While founders are building the business, they may also be considering how they take their select key staff along with them on that journey by keeping them incentivised. In particular, founders will be wary of committing to pay large packages when they are not clear on the scale the business will achieve. As such, the founders should look at options which allow these key individuals to participate in the value of the business as it grows.
“There are generally three main ways in which a founder can realise value from a business: profit extraction, a partial exit, or a full exit,” says Montague. “No matter the method, it is important to complete this value extraction in the most tax efficient manner possible.”
Taking professional advice prior to any of those events taking place is recommended, as the rate of tax incurred can make a substantial difference to the attractiveness of the offer on the table. The aim will be to achieve capital gains tax treatment, whether that is a 10% (with ER) or 20% tax rate, as opposed to being taxed at up to 45%. However, the applicable tax rate will be determined by what is being offered or the transaction being undertaken.
The tax incurred on an exit can also depend on what the purchaser of the business is offering by way of consideration. “If the sale is for cash, it is relatively simple, but they could be offering something more complicated,” says Ebrahim. “They could offer something that ties the founder to the business going forward, such as a rollover into a private equity structure or an earn out which depends on future performance. This complicates the timing of when tax is due, the amount that is due and also if there is relief if the amounts eventually paid out are less than what was expected at the point of sale.”
A key point to remember is that from an inheritance tax perspective, the shares owned by a founder in an unquoted trading business would probably qualify for Business Property Relief. This means if the founder were to die and pass on those shares, there would be no inheritance tax levied on those shares. In contrast, if a founder sells the business or shares for a cash sum, that cash is subject to inheritance tax on death.
“By selling your business, you're actually selling inheritance tax protection as well,” says Montague. “By turning shares into cash, you've given your heirs a 40% inheritance tax problem. It’s something many founders might not realise.”
The post-exit stage is often the furthest thing from an entrepreneur’s mind when running the business or whilst going through a sale process, but it is important to think about what they might do with the cash realised from a sale. “Whilst a founder has shares in a business, they will typically consider the business as the riskiest part of their wealth profile. This can also give you an unrealistic idea of returns on wealth in future,” Montague explains.
“The cash made from a business sale can’t be invested with a wealth manager with the same expectation for returns that they achieved with their businesses where they can see their investments achieving very high multiple returns. However, the cash can be invested with a view of achieving modest, safe returns with a plan for wealth preservation.”
“We often have clients come to us who are concentrating solely on the sale of their business, but they haven’t considered who will manage their money, how to structure their new wealth and how they will invest that money to preserve it in future. We can introduce them to wealth managers who understand tech entrepreneurs and can meet their requirements as well as advise them on how they provide for their families with the newly generated wealth by way of succession planning. In addition, there are ongoing personal tax considerations that can emerge from exiting a business,” says Ebrahim. “Updating your Will, implementing a succession plan, and getting your affairs in order should all be part of the post-exit process.”
For many tech founders, the exit of a business is the launchpad for beginning another. “Exiting starts off a new business lifecycle, and as advisors, we help plan for the new business. This includes focussing on how founders tax efficiently, fund the new venture, or angel investments they may be interested in,” says Montague.
Like to know more about your personal tax obligations as a tech founder? Get in touch by emailing [email protected].
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