Succession planning – income tax considerations
The recent upturn in the economy has resulted in a renewed interest in succession planning. Often the focus of practitioners is on the main tax heads normally associated with succession planning (i.e. Capital Gains Tax (CGT), Capital Acquisitions Tax (CAT) and stamp duty). The purpose of this article is to examine the main income tax implications of succession planning for unincorporated trades and companies where assets are gifted from parent to child1.
Unincorporated trades (or professions)
The transfer of a sole trade or partnership interest from a parent to a child will result in a cessation of the trade for the parent and likely a commencement of a trade for the child. This will result in the cessation accounting provisions applying to the parent and the commencement accounting provisions applying to the child.
Broadly, the cessation provisions provide that the profits to be charged to income tax for the year of assessment in which a trade is discontinued are the actual profits of the period from 1 January in that year of assessment to the date of cessation. In addition, where the actual profits of the penultimate year of assessment (i.e. the profits on the calendar year basis) exceed the profits on which a person has been assessed for that year, an amended assessment is made to charge the excess. Such a revision only occurs where accounts are made up to a date other than 31 December and the profits of the trade are increasing.
With regard to the commencement provisions, the profits subject to assessment for the first year are based on the profits arising from the commencement date of the trade to the following 31 December.
The profits assessed to income tax for the second year of assessment are dependent on a number of factors.
- If only one set of accounts is prepared for a 12 month period ending in the second year of assessment the individual is chargeable to income tax on the profits of that 12 month set of accounts.
- If there is only one set of accounts for a period ending in the second year of assessment and the accounts are for more than 12 months, the individual is charged to tax on the profits of the 12 month period ending on the accounts date.
- If there are more than one set of accounts ending in the second year of assessment, the individual is assessed on the profits of the 12 month period ending on the date of the latest accounts provided that date is at least 12 months after the commencement of the trade.
- For any other cases the assessment for the second year of assessment is based on the full amount of profits on a calendar year basis.
With regard to the third year of assessment, this is normally based on the latest 12 month period of account in that year. If the profits assessed for the second year of assessment exceeds the actual profits of that year (i.e. the profits calculated on a calendar year basis), the taxpayer may elect to reduce the assessed profits for the third year of assessment by the amount of that excess.
The gift of assets such as plant and machinery2 on which capital allowances have been claimed is an event that can possibly give rise to a balancing allowance or charge. The balancing allowance or charge is based on the open market value of the assets that were gifted; in this regard a balancing charge could give rise to an unexpected liability to income tax for the parent thus increasing the overall tax cost of the gift.
However, it is possible in certain circumstances for the parent and child to jointly elect to Revenue to transfer the asset for capital allowances purposes at the tax written down value of the asset. Such an election would avoid a balancing allowance or charge arising for the parent although the child, on a subsequent disposal of the asset, is treated for capital allowances purposes as if the capital allowances claimed by the parent on the asset were claimed by the child thus potentially giving rise to a larger balancing charge.
The position of trading stock must also be considered on the transfer of a trade. Broadly on cessation of the trade the trading stock is to be valued at the amount that it would have realised if it had been sold on the open market at the discontinuance of the trade. This may give rise to an increased level of profit in the trade if the stock has increased in value since acquisition. It is not possible to make an election to transfer stock at cost in the case of a gift. However, the position with regard to farmers is different and such an election may be possible.
The gift of shares in a company from parent to child does not carry the same income tax implications as the transfer of an unincorporated business e.g. there is no cessation or commencement of a trade, capital allowances and stock are not an issue. Generally the parent will have acted as a director of the company, following the disposal of their shares the parent may remain on or retire as a director of the company. Some of the key issues to consider are outlined below.
The pension position of any retiring director of a company should be considered prior to retirement to ensure that the funding of their pension scheme is sufficient and that the salary level of the retiring director is at optimum levels where appropriate. Where the pension funding is insufficient it should be possible to top-up the pension scheme by way of corporate pension contributions. Similarly, the child who is succeeding to the company should consider their own future pension requirements and whether it is appropriate to commence a pension scheme for themselves.
Consideration should also be given to whether a tax free termination payment can be made to the director upon retirement, the level of the payment that can be made tax free is dependent on a number of factors such as; years service, salary level and whether the retiring director has claimed or can claim a tax free lump sum from a pension. The maximum tax free termination payment is capped at €200,000.
If the retiring director is to remain on as an employee (or even a director with a reduced/no shareholding) consideration should be given to the PRSI class of the individual, this is because the applicable class of PRSI may change due to the disposal of shareholding and reduced control and involvement with the company (i.e. from PRSI class S to class A). The PRSI position of the child may also change as they may be commencing as a director or may becoming a controlling director.
The parent should also ensure consider their financial means before deciding to retire as a director and dispose of their shareholding. If a parent requires monies from the company to fund their retirement such monies are rarely to be taken by way of salary or dividend due to the high income tax costs, consideration should be given in such circumstances to undertaking a share buyback by the company that may qualify for CGT treatment (retirement relief from CGT may also apply to the buyback).
When advising on succession planning accountants should be sure to consider all relevant tax heads e.g. CGT, CAT, stamp duty, income tax and VAT. Failure to consider all relevant tax heads may result in unexpected liabilities to tax arising and also opportunities for tax efficiencies may be missed, appropriate professional advice should be sought in all cases.
Mark Doyle is director of Doyle Tax Consultants. He is the author of Capital Gains Tax: A Practitioners Guide 2nd edition updated to Finance Act 2015 publishing soon by Chartered Accountants Ireland.
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1 The income tax implications where assets are transferred on death are beyond the scope of this article
2 An examination of the balancing allowance or charge position with regard to the gift of assets such as industrial buildings or farm buildings is beyond the scope of this article.