Introduction
One of the most valuable assets that a small business owner may ever own in their lifetime is none other than their interest in their business. Such an asset can often be subject to large capital gains tax (CGT) upon the sale of the business by the owner.
Having spent blood, sweat and tears gradually building up a successful business, to see a large tax bill at the end can be very disheartening. Fortunately, for small business owners there are small business CGT concessions which can significantly reduce the CGT payable on the sale of a business. These concessions when combined with the 50% general CGT discount can, in certain circumstances, reduce the CGT payable to nil.
The small business CGT concessions comprise of the:
- 50% active asset reduction;
- 15 year exemption;
- small business retirement exemption; and
- small business rollover. Please note that there are threshold conditions which must be met before one can claim the small business CGT concessions, namely meeting a $6 million net asset test or a $2 million turnover test. This article assumes that these are met for the relevant small business owner, and focuses on how the business structure affects how a small business owner claims the small business CGT concessions.
INDIVIDUALS AND FAMILY TRUSTS
Owning your business as an individual sole trader or in a discretionary trust provides the most complete access to the small business CGT concessions and general 50% CGT discount. This is because the general 50% CGT discount is only available to individuals and trusts. Companies cannot claim the general 50% CGT discount.
Additionally, the benefit of the 50% active asset reduction can be passed down to individual beneficiaries of a discretionary trust without any offsetting tax detriments. This contrasts favourably with a company structure where providing shareholders with access to capital gains sheltered at the company level by the 50% active asset reduction is more complicated (see our discussion on companies below).
Example 1
| Capital gain | $1,000,000 |
| 50% general CGT discount | ($500,000) |
| Capital gain after 50% CGT discount | $500,000 |
| 50% active asset reduction | ($250,000) |
| Capital gain after 50% active asset reduction applied | $250,000 |
| Small business retirement exemption | ($250,000) |
| Capital gain payable after application of small business CGT concessions | $0 |
Example 1 shows the tax treatment for a sole trader who makes a $1 million capital gain on the sale of their business (this capital gain relates to business goodwill). Provided that the individual has owned their business for more than 12 months, they can claim the general 50% CGT discount to reduce their capital gain by half. The 50% active asset reduction can then be used to reduce the capital gain by half again. Finally, the small business retirement exemption can be claimed to reduce the remaining $250,000 taxable capital gain to nil. If the individual sole trader is under 55 years, then the $250,000 sheltered by the small business retirement exemption must be contributed to superannuation. This requirement does not apply where the sole trader is 55 years or more and the sole trader can keep the funds to deal with as they wish.
The tax treatment where a discretionary trust makes the $1 million capital gain is basically the same as outlined in Example 1, with the one difference being a requirement that the trust ensure that it distributes trust income related to the capital gain to an individual beneficiary or another trust. This is because if it distributes such trust income to a company then the benefit of claiming the 50% general CGT discount is clawed back. A discretionary trust can distribute amounts sheltered by the 50% general CGT discount (i.e. $500,000) and the 50% active asset reduction (i.e.$250,000) tax free to beneficiaries.
Obviously where one carries on business as a sole trader, there are asset protection risks which need to be weighed up against the ease in being able to claim these CGT concessions. Such asset protection concerns are not present where a discretionary trust with a corporate trustee is used.
FIXED (UNIT) TRUSTS
Unit (or other fixed) trusts are not as tax effective as discretionary trusts for passing down the benefit of CGT concessions claimed at the trust level. Whilst an amount sheltered by the 50% general CGT discount at the trust level can be distributed to unitholders in the trust tax-free, it is not possible to distribute an amount sheltered by the 50% active asset reduction without triggering tax consequences for a unitholder.
Let’s suppose that Example 1 shows the tax treatment for a unit trust which makes a $1 million capital gain. The trustee of the unit trust claims the 50% general CGT discount, the 50% active asset reduction and the small business retirement to reduce the trust’s taxable capital gain to nil. The trustee of the trust can distribute the $500,000 sheltered by the 50% general CGT discount tax free to unit holders. However, it may not be possible to distribute the $250,000 sheltered by the 50% active asset reduction to unitholders tax free.
This is because the distribution of the amount sheltered by the 50% active asset reduction at the trust level triggers CGT event E4 for the recipient unitholder. Broadly, CGT event E4 operates to write down the cost base that the recipient unitholder has in their units in the trust by the amount of the distribution and to the extent that there is an excess, the recipient unitholder makes a capital gain.
Where the recipient unitholder’s units in the unit trust meet the active asset test and they have held their units for more than 12 months, it may be possible for the recipient unitholder to claim the 50% general CGT discount and the small business CGT concessions at their unitholder level to reduce the taxable capital gain made under CGT event E4. However, you can see that it is a much more involved process in passing down the benefit of the $250,000 sheltered by the 50% active asset reduction at the trust level, than in the case of a sole trader or discretionary trust where the $250,000 amount can be accessed without further tax consequences.
It is possible to avoid having to deal with the CGT event E4 tax issue related to distributing an amount sheltered by the 50% active asset reduction at trust level in a number of ways.
Firstly, the business owner could sell their units in the unit trust rather than selling the business from the unit trust. For this option to be tax effective the units would need to meet the active test – this will be the case where broadly 80% of the assets held by the unit trust are active business assets. Under this option the business owner essentially places themselves in the same position as the sole trader discussed above since they are claiming the CGT concessions at their individual level. The main issue with this option is that many purchasers are reluctant to acquire an entity structure where they do not know its history.
Another way to avoid CGT event E4 is for the unit trust to claim the 15 year exemption to exempt the whole of the $1 million capital gain made (where the 15 year exemption applies there is no need to claim any other CGT concession). A unit trust can distribute an amount sheltered by the 15 year exemption at trust level tax free to its unitholders. Practically, however, it can be difficult to claim the 15 year exemption since it requires the business to have been owned for 15 years with there being a relevant significant individual behind the trust for each of the 15 years. As a consequence it is more common for taxpayers to claim the 50% active asset reduction and small business retirement exemption than the 15 year exemption.
It is possible to use the small business retirement exemption to overcome the CGT event E4 tax issue. Example 2 below illustrates this.
Example 2
| Capital gain | $1,000,000 |
| 50% CGT discount | ($500,000) |
| Capital gain after 50% CGT discount | $500,000 |
| Small business retirement exemption | ($500,000) |
| Capital gain payable after application of small business CGT concessions | $0 |
In Example 2, the trustee of the unit trust chooses not to apply the 50% active asset reduction and instead claims the small business retirement exemption to exempt the remaining $500,000 capital gain. The $500,000 amount sheltered from tax by the small business retirement exemption can be distributed to a unitholder who is a significant individual tax free. Where the significant individual is under 55 years then the $500,000 amount would need to be contributed to their superannuation.
The small business retirement exemption has a $500,000 lifetime limit per individual and so the individual in Example 2 will have fully used up this exemption. This contrasts with the situation of a sole trader or discretionary trust in Example 1 where only $250,000 of the small business retirement exemption had to be claimed since the 50% active asset reduction could be claimed without the issue of CGT event E4. Accordingly, the use of a sole trader or discretionary trust structure preserves the benefit the small business retirement exemption for use in later years on other business ventures.
COMPANIES
Companies are the least favourable structure for CGT purposes, notwithstanding their other income tax benefits such as the lower 30% company tax rate.
This is because companies cannot access the 50% CGT discount. Additionally, a company can only tax effectively distribute amounts sheltered by the 50% active asset reduction at company level to shareholders on liquidation. This can be seen in Example 3 below.
Example 3
| Capital gain | $1,000,000 |
| 50% active asset reduction | ($500,000) |
| Capital gain after 50% active asset reduction | $500,000 |
| Small business retirement exemption | ($500,000) |
| Capital gain payable after application of small business CGT concessions | $0 |
In Example 3 the company makes a $1 million capital gain and claims the 50% active asset reduction and small business retirement exemption to reduce its taxable capital gain to zero. If the company distributes the $500,000 sheltered by the 50% active asset reduction to shareholders then that distribution will be taxed as an unfranked dividend in the shareholders’ hands. No franking credits would attach to such a dividend.
The only way that the company can tax effectively distribute the $500,000 is by paying it out as a liquidator’s distribution. Where this occurs, the $500,000 is not treated as a dividend in the shareholders’ hands. Rather it is treated for tax purposes as representing capital proceeds paid on the cancellation of the shareholder’s shares on liquidation. A shareholder makes a capital gain on receipt of these capital proceeds to the extent they exceed the shareholder’s cost base in their shares. The shareholder may be able to claim the benefit of the small business CGT concessions and the 50% general CGT discount to reduce their taxable capital gain where the shareholder meets relevant conditions.
Once again you can see it is a very involved process to pass down the benefit of the 50% active asset reduction to shareholders, as compared to the sole trader and discretionary trust example discussed above. Liquidation generates additional costs. For instance, where the company has other assets and liabilities besides the business which is being sold, it may not always be easy to liquidate the company since there may be tax consequences in removing these other assets and liabilities.
Where a company can claim the 15 year exemption to wholly exempt the capital gain then there is no need to liquidate since amounts sheltered by the 15 year exemption at the company level can be distributed to a shareholder without triggering tax. However, as discussed above it is not often that the conditions of this exemption can be met.
Amounts sheltered by the small business retirement exemption at the company level can also be distributed to shareholders tax free. However, where the capital gain is large it may not be possible to use the small business retirement exemption to offset all the capital gain since the exemption is subject to the $500,000 lifetime limit per individual. This can be seen in Example 3 where the $1 million capital gain exceeds the $500,000 small business retirement exemption limit and the 50% active asset reduction has to be used to reduce the capital gain to nil.
Summary
The importance in accessing the small business CGT concessions for business owners is critical as it will often be the difference between having to pay a CGT liability or not. Appropriate consideration should therefore be taken to ensure a client’s business is appropriately structured from the outset to enable maximum access to the small business CGT concessions. If one’s business structure is not appropriately set up, it may be possible to restructure. However, there may be CGT and stamp duty consequences.
