A company can close due to insolvency or through voluntary closure of a solvent company. When this process takes place, the assets are distributed. How they are distributed depends on the route you take to close the company. Which brings up the question: what is a cash liquidation distribution? This guide will explain this and much more. First, let’s discuss the meaning of liquidation.
What is Liquidation?
When a company becomes insolvent, then it sells off the business assets to settle claims from creditors. This processing of shutting down an insolvent company is called liquidation. The court appoints a liquidator to supervise the process. What is the main purpose behind liquidation? Liquidation aims to ensure that creditors get paid, and that everyone involved is treated fairly. Furthermore, liquidation closes the company’s operations on time and legally. According to their assigned priority, this process pays back creditors. For example, Secured a Bank or unsecured, Preferential HMRC, trade creditors.
How Does Liquidation Work in the UK?
There are two main types of liquidation in the UK: Voluntary Liquidation Process: This process is initiated by the company’s directors. The liquidator is a licensed insolvency practitioner. Compulsory Winding Up: Whereas the court orders for compulsory wind up. Either the company’s shareholders or a creditor can request for it. The liquidator, in this case, is an official receiver. The first task of the liquidator is to gain control of the assets of the company. They do this to figure out how much money is available to pay off the creditors of the company. This is true for both types of liquidation. Then, the liquidator must sell off the assets.
Proceeds of the sale pay off the creditors. If there are remaining funds, then the shareholders will receive them. Then, what is a cash liquidation distribution? This process is undoubtedly complex and time-consuming. It can take several months to complete the process of liquidation. Please note that the directors of the company lose control over the company during this process. Therefore, it can no longer conduct business.
What is a Cash Liquidation Distribution?
When a solvent company closes and their assets are more than their liabilities, then this situation is called a capital distribution. Once the company pays off its debt, they turn the assets into capital, i.e., cash. Then, the shareholders of the company receive this capital distribution.
Different tax rules apply to the different liquidation processes. You can go the formal route or dissolve your company. The latter is faster and less expense. Of course, you must weigh the advantages and disadvantages of each process. Otherwise, how will you know how best to proceed? You must consider the tax position on the distribution of the assets of the company once the company closes. Any money that shareholders receive from the company that is subject to Capital Gains Tax (CGT) is called a capital distribution. It is not income. Therefore, income tax does not apply to it.
Usually, companies distribute in the form of income distributions. For example, dividend payments. Income tax applies to these distributions. Yet, capital distribution is possible. That is, if it is through the winding up of a limited company. Now, you know what is a cash liquidation distribution?
What if Directors and Shareholders Want to Close a company?
If the situation arises where the shareholders and directors want to close the company, then they have two options. In this situation, the company is solvent. This means it can pay off outstanding debts. One option is to go for an informal company strike-off. Often, it is called a company’s dissolution. Or they have the option for a member’s voluntary liquidation (MVL). The major difference between these two choices is how the tax applies to the distributions.
How Does Tax Apply to Capital Distribution?
Let’s look at how tax is applicable to capital distributions of a company:
Option One: Informal Strike-off
If the shareholders and directors decide for an informal strike-off, then the limit is £25,000. To simplify, the maximum amount of company assets and share capital that is eventual distribution is £25,000. In case of profits exceeding this amount, income tax is applicable to them. Each shareholder must pay income tax on the distributions they get. They must do so at their personal income tax rate.
The company’s shareholders get the profits above the limit in the form of final dividend. Different tax rates apply to those dividends. They depend on the shareholder’s personal rate of income tax. For example, 7.5 pc, 32.5 pc, 0r 38.1 pc. If the profits are below the £25,000 limit, then all the shareholders pay Capital Gains Tax at 10 pc or 20 pc. The former is for basic rate income taxpayers, while the latter is for higher rate income taxpayers. Although, you can still pay only 10 pc regardless of your income tax rate. That is, if you qualify for Entrepreneur’s Relief. Therefore, it is important to know what is a cash liquidation distribution.
Option Two: Members’ Voluntary Liquidation (MVL)
The other option available to directors and shareholders is an MVL. Which is a member’s voluntary liquidation. This procedure is formal, as the Insolvency Act 1986 governs it. It is used to close a solvent company. A licensed insolvency practitioner will value the physical assets, sell them, and turn them into cash. They will do all this before closing the company. Then, the company’s shareholders will receive their cash distributions. This option is more tax efficient if you want to close a limited company that has assets and share capital worth more than £25,000. Especially if you are a higher rate income taxpayer.
In this case, Capital Gains Tax (CGT) is applicable on all shareholder’s distributions. Therefore, it is an ideal option if the company has high levels of profit that it retained. Moreover, shareholders qualify for Entrepreneur’s Relief in a Member’s Voluntary Liquidation. Thus, you should consider the upfront expenses of an MLV. For a company that is small or medium-sized, it is around £2,000 plus VAT. That is, if the company has no physical assets but has cash in the bank. In certain situations, a company’s distributions are subject to income tax if it chooses this option. Such scenarios include the following:
- The main purpose behind MVL was to gain a tax benefit and not an honest desire to close the company.
- Within two years, a director or shareholder who received a distribution gets involved in a similar trade.
This answers the question what is a cash liquidation distribution?
Is there Entrepreneurs’ Relief on Liquidation in the UK?
Through Entrepreneur’s Relief, shareholders have the advantage of paying Capital Gains Tax (CGT) at a lower rate. The qualifying shareholders pay Capital Gains Tax (CGT) at 10 pc rate instead of 20 pc. This applies to the gains of all the qualifying assets. They sell these assets through member’s voluntary liquidation. Furthermore, you can avail of Entrepreneur’s Relief of a strike-off procedure as well. To quality profit must not exceed £25,000.
Do You Qualify for Entrepreneurs’ Relief?
Your eligibility for Entrepreneur’s Relief depends on you meeting at least one of the following criteria:
- You own at least 5 pc of the shares, voting rights or securities of the company that is closing. Also, you could qualify if you purchased 5 pc of the shares one year prior to the company’s closure. Or if the company is involved in trading rather than investment and you were an employee there for one year.
- As a business trader or sale trader, you are disposing of the business. Either all of it or part of it. Before selling it, you must own it for more than a year. Additionally, within three years, you must sell the assets.
- You gave an asset to the business that is facing closure. Although, it is only applicable if the asset is in use for a year before closing. Or if you sold 5 pc of your stake in the business beforehand.
Please note that no limit exists for the number of businesses you can close or sell under this scheme. This is for the entire duration of your career. Nevertheless, a £1million lifetime limit exists on Capital Gains Tax (CGT). After exceeding this limit, you can no longer avail Entrepreneur’s Relief. Therefore, you should know the answer to the question what is a cash liquidation distribution?
How Fast Do Shareholders Get Paid in a Members’ Voluntary Liquidation?
If the case is simple and no outstanding liabilities exist, then the liquidation and dissolution of the company takes six months. Nevertheless, shareholders can get capital distribution before this period. That is not uncommon. Through a signed indemnity, this process takes place.
This indemnity is a form of protection in case creditors make claims after distributions of capital. As a result, shareholders will get most of the funds immediately. Yet, they keep a small portion until the official closure of the company. This small amount covers the liquidator’s fee and cost of disbursements. Then, the shareholders will receive the remaining funds.
To summarise, you can close your company if you wish to. You have two options as to how you proceed with the closure. Both procedures have their pros and cons. Not to mention that tax applies differently to each of them. Therefore, one must understand which option is suitable for their company. The shareholders can receive capital distribution through the closure of a company.