When we first started working together, tax was the last thing on our minds. But that quickly changed once it was time to incorporate. Sad face. Seasoned entrepreneurs tax-plan right from the start, especially when building companies they may eventually sell. Here’s why:
If you want any restrictions on shares, e.g. leaver provisions, in your company startup then you have to pay up to 40%+ income tax on any gains. However, you can pay much less – as little as 20% CGT or even 10% (if Entrepreneurs’ Relief applies) – if you put a tax-efficient arrangement in place.
And this applies regardless of whether you use Slicing Pie or a fixed split.
Now, you could just pay 40%+ income tax on your gains. However, if you’d rather pay 20% CGT or even less and want to use Slicing Pie, we can help!
We’ve developed UK HMRC-friendly legally-binding grunt fund solutions that:
- ensure you and your team share equity fairly in line with Slicing Pie, and
- mean you can pay 20% CGT – or 10% if Entrepreneurs’ Relief applies – on any gains if you ever sell.
Heads up: this post is long. However, it’ll help you understand why HMRC taxes shares in the way that it does, and why this matters for owners of Slicing Pie company startups.
I thought you only pay CGT when you sell shares?
You do. But only if they’re shares in companies you don’t work for.
If you work for a company, whether as a director, officer or employee, then – unless they’re unrestricted or certain conditions are met – gains on your company shares are subject to income tax – because HMRC classes these as employment-related benefits.
So how does HMRC tax shares?
HMRC basically taxes shares in four ways, depending on whether:
- they are shares in a company you work for (box A),
- they are restricted or unrestricted (box B), and
- you have made tax elections or not (box C).
Ordinarily, if you buy shares in a company you don’t work for, then when you sell them, you pay CGT on your gains. These kinds of shares are ones you might buy for investment, e.g. on a stockbroking platform or through your financial advisor, for example, in the FTSE 100.
At 2020-21 rates, this means that you pay:
- 0% on the first £12,300 of your gains, which is your tax-free CGT allowance; then
- 10% on your gains to the extent that they fall within any unused part of your basic rate tax band, which covers income and gains up to £50,000; and
- 20% on any gains that exceed your basic rate tax band, e.g. if you’re a higher rate taxpayer.
However, shares which are issued to you by the company you work for – whether as a director, officer or employee – are treated differently, depending on whether they are restricted or unrestricted.
Unrestricted shares are shares that don’t have any rules reducing their ability to be owned or transferred. This means team members can do whatever they like with their shares, e.g. sell or give them away whilst they’re still in the business, or keep them if they leave the company.
HMRC treats unrestricted employment-related securities as employment-related benefits – and these are always subject to income tax. This means that:
a) directors, officers and employees pay:
i) CGT on sale gains, and
ii) income tax and employee NICs upfront on any discount they got when they were issued, and
b) the company pays employer NICs on that discount value at the time of the grant.
In contrast, restricted shares are shares that have provisions reducing their owner’s ability to sell or transfer them. These provisions are called “restrictions”. Companies use these in order to incentivise staff, but still keep control as the company grows. For example, to stop a minority shareholder from blocking a sale even if they only own 1% of the company, or to ensure that employees who are fired for good reason can’t keep all of their shares. Things like pre-emption rights, drag-along rights and tag-along rights2, and good and bad leaver provisions all count as restrictions.
However, share restrictions affect how shares are taxed – because shares with restrictions can’t be so easily sold. Restricted shares are therefore less valuable when they’re issued to staff.
Why does this matter? Well, because people used to be cunning. Staff would buy restricted shares at a very low price and pay low or no income tax initially. Then companies would lift the restrictions just before sale, so that CGT could apply to a much bigger gain.
HMRC soon cottoned on, so in 2003 it introduced the “restricted securities regime” to stop people doing this. Under these rules, companies and their shareholder-workers now have to pay up to 40%+ income tax on their restricted share gains (see C.1 below), unless they:
- make an election under the restricted securities regime to pay CGT on their gains (see C.2 below) provided they pay income tax upfront on their restricted shares as if they were unrestricted (spoiler alert: this is what we did); or
- use a share scheme like CSOP, EMI or SIP to reduce their tax. Some of these HMRC schemes have attractive tax benefits, but as they’re designed for fixed equity we’ve not found any that work yet for Slicing Pie.3
And if you haven’t made any elections or put a share scheme in place, then HMRC hunts hard for restrictions, in order to increase the tax it can get.
HMRC taxes restricted shares in a company you work for differently, depending on whether or not a tax election is made jointly by you and your company:
C.1 if no tax election is made (“restricted employee shares with no election”) then:
a) directors, officers and employees pay:
i) income tax and employee NICs on any gain, both when the shares are eventually sold, and each time before then if and when any of the restrictions are lifted, but
ii) no CGT; and
b) the company pays employer NICs on any gain, both when the shares are eventually sold, and each time before then if and when any of the restrictions are lifted.
C.2 if a tax election is made (“restricted employee shares with an election”):
a) directors, officers and employees pay:
i) CGT on sale gains, and
ii) income tax and employee NICs upfront at the time that they get them, on the value of the shares as if they were unrestricted; and
b) the company pays employer NICs upfront on the unrestricted market value.
Great, I’ll make an election!
Elections are great if you want a lower tax rate to apply to your gains. That’s what we went for. However, before you get too excited, elections don’t work for everyone. First, elections can only be made on shares or securities that have identifiable restrictions (which is the legal bit). Second, making an election is a bit of a gamble. Why? Because:
- HMRC won’t tell you or your company beforehand what it thinks your restrictions are worth, and therefore how much income tax and NICs you each have to pay;4
- elections have to be made within 14 days of your shares being issued, otherwise they won’t be valid; and
- if you make an election and pay income tax and NICs upfront but don’t ultimately sell for a gain, you can’t get a refund.
So if your company is already worth something but your shares don’t eventually sell for a gain, electing could cost you more in tax and fees than you’ll save. Hmm, tricky.
But good news for founders of early-stage startups
However, elections work well when a company isn’t worth very much. That’s because when there are very few assets, it’s easy for HMRC to agree that restrictions make little – or no – difference to your share value, such that your company’s shares are worth pretty much what you paid for them. In which case your upfront income tax charge will be zero, or low.
So elections are worth thinking about if you’re a founder of an early stage startup which hasn’t yet got much of value5, and which may eventually sell for a gain.
What does this have to do with Slicing Pie?
Basically, Slicing Pie has fair-sharing concepts that, as far as HMRC is concerned, act like restrictions.6 For example, it has built-in leaver provisions that require a grunt to forfeit some or all of their stake if they resign without cause, or are terminated with cause, before a grunt fund is split. These are great – they’re one of the reasons people love Slicing Pie.
However, the book doesn’t document legally how it should apply to your company, which means that if you issue shares without putting an agreement in place, you have to trust that those shareholders will sort them out in accordance with Slicing Pie.7 And it doesn’t specify restrictions on shares in a way that HMRC can identify and value for income tax purposes, which means you can’t get the benefit of making CGT tax elections.
Thus if you want to incorporate, issue shares and avoid paying income tax on your gains, you need to document legally how Slicing Pie should apply to your company and restrict your shares.
We can help
If you’d love a Slicing Pie company setup that could save you tax when you sell, then we provide startup solutions, including:
- shareholders’ agreements and articles of association that:
- set up a company so that it runs in line with Slicing Pie, including how pie is earned, your grunt fund splits, and how good and bad leavers are treated,
- allow grunt directors, officers and employees to own company shares in proportion to pie,
- let grunts elect for CGT treatment on gains, meaning they can pay up to 20% CGT on share gains when they sell – or even 10% if Entrepreneurs’ Relief applies;8and
- enable you to set out how your business should run and make decisions;
- intellectual property agreements that ensure that each grunt’s work and IP belongs to the company and can be counted for pie slices; and
- finance agreements, so that you can properly account for any monies you put into the business both for tax and pie.
If these are just what you need, talk to us about how we can help. We’ll be delighted to hear from you.
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1 You can pay even less CGT if you’re an investor in an unquoted company, e.g. under Investors’ Relief, SEIS or EIS. However, various rules apply before you can qualify, e.g. you can’t generally work for the company and you have to hold shares for at least three years.
2 Quick reminder: drag-along rights require all shareholders to sell if an offer is accepted by more than e.g. 50% of the shareholders. Tag-along rights enable minority shareholders to ensure they’re not left out or offered less, if a majority shareholder receives an offer for their shares alone. And pre-emption rights require shares to be offered to existing shareholders first pro-rata, before they can be sold to third parties, i.e. to stop sneaky selling.
3 We’d love it if an existing HMRC share scheme gave tax breaks for fair equity sharing. However, we’ve not yet found any that work for Slicing Pie startups. For example, some have conditions that mean they can’t be truly dynamic (e.g. EMI and CSOP don’t let staff hold more than 30% of the shares). Others need share options to be held for a minimum number of years (e.g. SIP, SAYE). And some only allow employees to qualify if they work for a minimum number of hours, which would be problematic for grunts working on startups in their spare time (e.g. EMI, SIP).
4 Not only does it not tell you before. It also doesn’t tell you after: HMRC withdrew its employment income and ITEPA post-transaction valuation check service in 2016. So now once you’ve made an election, you just have to submit your tax return with what you and your accountant think is an appropriate share valuation, and wait to see if HMRC agrees.
5 Remember, your idea may be great, but if you haven’t developed it, it remains just that – an idea. It doesn’t become worth something until it gets baked into pie. (We know: gutting.) If you need a reminder, read Moyer, Mike. Slicing Pie: Funding Your Company Without Funds, v.2.3, 2012. Lake Shark Ventures LLC. Print. p.20-21.
6 HMRC looks for restrictions everywhere, so even unwritten agreements can count.
7 And also, you’ll likely end up with a horrible legal and tax mess.
8 And because we’re anal like that and thought it would be good for our own setup, our Slicing Pie documents also include pre-emption rights, tag-along and drag-along rights so that restrictions continue if your grunt fund automatically splits because it is profitable.