Pre-sale due diligence: don’t get caught out

Broking Business - December 2023

read timeRead time: 29 mins

Two common employment tax-related errors could cause you real problems when it’s time to sell your business. Here’s how to avoid the pitfalls that can threaten a smooth sale.

In our due diligence work for insurance intermediary businesses, we often identify employment tax-related issues. Though not specific to the sector, two in particular are common in small to medium-sized owner managed businesses.

In both cases, if identified as part of due diligence, they could lead to additional liabilities that reduce the consideration paid. It could also mean additional protections and indemnities are included in the purchase agreement. And time would need to be dedicated to rectifying the tax position rather than focussing on getting the deal agreed.

Which costs are business costs?

Business expenses are generally those incurred in the ordinary course of running a business. These can include costs of entertaining, travel and subsistence. But beware, as not all entertaining, travel and subsistence costs are necessarily business costs.

A director shareholder who takes their family on holiday and pays for this using the company bank account is clearly not incurring the cost in the ordinary course of business. This is therefore a private expense of the director.

That may be an extreme example, but what about the director who travels to meet clients and then extends the time travelling and takes their family with them? Or when a business has season tickets at a sporting venue, which are sometimes used to entertain clients but also used by friends and family?

Why does this matter? Because business expenditure is generally not taxable on the employee or office holder, whereas private expenditure is.

How this expenditure is taxable depends on who arranges the supply, and whether the business pays suppliers directly or whether the employee pays for the private expenditure and is then reimbursed by the business.

Ultimately, the private costs must be included as earnings in the company’s payroll, with PAYE and NICs deducted, and paid to HMRC or included on a form P11D as a benefit in kind.

Where these costs are identified as part of the due diligence process, we often discover that none have been processed through the payroll or recorded on a P11D.

What’s more, there is often a lack of clarity and documentation to show whether these costs do represent business expenses or whether they are privately paid by the business owner and therefore should be reported to HMRC.

We have seen examples where businesses have incurred significant levels of expenditure on travel or entertaining over several years. These amounts have not been reported to HMRC, nor been processed through the payroll. No evidence is provided as part of the due diligence that these represent business expenses.

This means a purchaser could be acquiring a company with potential exposure to considerable liabilities. This would happen if HMRC investigated the position and found that these expenses were private and therefore taxable on the business owner.

Employing family members

Members of a director’s or business owner’s family can be employed in the business, just like any other employee. But it’s important that they are carrying out employment duties and are remunerated at a level that is commensurate with those duties.

Too often it’s seen as a way of reducing overall tax liabilities. This is done either by paying part of the director’s salary to the family member, even though they do not actively work in the business, or by paying an inflated salary to the family member who performs limited duties for the business or may only work part-time.

HMRC has anti-avoidance rules which require that a portion of the family member’s salary, or all of their salary where the individual is not carrying out any employment duties, is reclassified as earnings of the director.

This, in turn, incurs additional tax liabilities. The director would typically have a higher income and therefore be taxable at a higher marginal rate of tax.

Once again, these kind of issues are usually spotted through the due diligence process. Either it becomes clear that a family member does not work in the business. Or, if they do, they aren’t paid a salary that is commensurate with their role or the hours they work each week.

As with any other employee, HMRC expects family members to have an employment contract that clearly sets out their role, working hours and their remuneration.

Again, this would leave a purchaser in the position where the company they are acquiring has a potential exposure to additional PAYE and NIC liabilities.

What should businesses do?

These two situations give rise to significant additional liabilities. They can cause substantial delays in a deal process or, in some circumstances, cause a deal to be paused or fall through completely. This is because the purchaser is not willing to proceed with the transaction until the position has been rectified and the risk removed.

Businesses and business owners must make sure they apply the correct tax treatment to these situations, and that they are compliant with the tax rules. And, from a deal perspective, it’s just as important to be able to demonstrate that compliance with clear evidence.

We would suggest that, as far as possible, private expenses are not included within the business but are paid for by the individuals and kept separate from the business.

Similarly, companies should only pay a salary to family members who are employed by the business. The level of that salary should be representative of the work they undertake. Contemporary evidence to support the work that they perform will be invaluable in responding to any challenge.

If you think your business will be going through a sale process in the future, it’s often a good idea to engage with your tax advisors in advance and ask them to carry out a review of your tax position. This can help identify any errors or issues at an early stage and, importantly, allows time for these to be fully corrected before the sale starts. This, in turn, leads to a more straightforward due diligence process.

If you would like further guidance on any issues raised in this article, please contact Tom Golding.