The process by which a business is transferred out of a limited company and carried on subsequently by a sole trader, a partnership or a limited liability partnership is commonly referred to as “disincorporation”. Usually, this is undertaken because the owners of the company no longer want to be burdened with the additional rules and obligations that running a limited company entails.
Although carrying on a business through a company can be very tax-efficient it may not always make enough difference to justify the additional costs incurred and constraints applied in operating through a company structure. Unfortunately, disincorporation is a more expensive and complicated process than incorporating a business in the first place. Many of the difficulties relate to taxation as there are no statutory reliefs to assist a disincorporation as there are with incorporation. The main issues are considered below. Except where indicated it is assumed that the company in question is a trading company. Some, but not all, of the comments below, would be equally applicable to an investment company.
Tax Consequences for the Company
When a company ceases trading and accounting period comes to an end for tax purposes. Any Corporation Tax (“CT”) for that period will be due nine months thereafter. The transfer to the shareholders of company assets such as land and buildings, goodwill, and other intangible assets such as intellectual property, copyrights, patents and trademarks, etc may give rise to additional CT liabilities depending upon their value. Where these transfers take place after trading has ceased such profits as arise may be taxable at the full CT rate of 26%.
When transfers of land (and buildings) take place the stamp duty land tax position will always have to be considered. Generally speaking, this will be avoided if the transfer is made to the shareholders as part of a winding-up procedure of the types explained later in this letter. However, even on a winding-up, any transfer of an associated third party loan or mortgage to the shareholder would represent an effective payment to the company for the acquisition of the land, giving rise to a potential stamp duty land tax charge.
Any trading losses of the company which is unutilized at the date that trading ceases will be lost. There is no facility to pass them on to the new owners of the business. Nor will they be available to reduce the tax on profits made on the transfer of assets to the shareholders as described above where this takes place after trading has ceased.
The transfer of any closing stock and work-in-progress takes place at market value although in most cases the parties can jointly make a formal election to transfer the stock at an agreed value, as long as this is not less than the book value. Similar rules are available for work-in-progress but in service industries, following recent changes in Standard Accounting Practice, there may not be a material difference between book value and market value in any event.
The company will not be able to claim any capital allowances in respect of items such as plant and machinery for its final trading period and may even have some allowances which have been claimed in previous years clawed back depending upon the value of the plant at the date the trade is transferred. Although both parties can make a joint election for such assets to be transferred at their tax written down value so that no clawback occurs, it may be preferable if the company has unrelieved losses to allow these to be used, as far as possible, against any clawback that may arise. The assets transferred will then have a higher tax cost to the new owners of the business and they will be able to claim more capital allowances accordingly.
To enable the trade to continue in an unincorporated form it will often be necessary to complete forms VAT61 and VAT68 to transfer the VAT number, allow continuity of trade, and avoid a new VAT registration which can take some time to obtain. In this respect however it should be noted that where a VAT number is transferred in this way past obligations are also transferred. The actual transfer of the business and its assets to the shareholders will not constitute a taxable supply for VAT purposes provided that it satisfies VAT regulations on the basis that it is the transfer of a business as a going concern.
Procedures for Winding-up the Company
To effect the transfer of the business out of the company to the shareholders it will usually be necessary to wind-up the company and this can be done either by a formal liquidation or it may be possible to consider an informal dissolution under Section 1003 Companies Act 2006 This would involve paying off the company’s creditors and then distributing the remaining assets to the shareholders prior to arranging for the company to be struck off the register. The informal procedure is cheaper to implement than the appointment of a liquidator but whichever route is preferred it will usually be important to ensure that the distribution of assets made to shareholders is treated as capital and not an income distribution for taxation purposes. This is because of the lower rates of Capital Gains Tax (“CGT”) in comparison to income tax and the greater availability of reliefs, such as the CGT annual exemption and possibly Entrepreneurs’ Relief. Distributions made in a formal liquidation will be statutorily treated as capital distributions unless anti-avoidance provisions apply (see below).
Distributions made under the informal procedure will be treated as income distributions unless prior HM Revenue clearance is obtained under Extra Statutory Concession C16. This concession is currently being reviewed by HM Revenue and whilst it is proposed to convert its provisions into a statutory relief their scope is likely to be much reduced. It is therefore possible that the appointment of a liquidator may almost always be necessary in the future to ensure capital treatment. In addition, it should be noted that, for technical reasons, it will not usually be advisable to undertake an informal winding-up where the issued share capital of the company exceeds £4,000 unless the value of issued share capital is first reduced to below £4,000 via a reduction in share capital (now a reasonably straightforward process under the Companies Act 2006).
Tax Issues for the Shareholders
Assuming that the distribution of assets from the company on the winding-up is a capital distribution, as described above, then the shareholders will make a capital gain if the value of the cash or other assets they receive exceeds the original cost of their shares in the company. In many small to medium-sized companies, the shareholders will have subscribed for their shares for only a few pounds and therefore the likelihood is that most of what they receive will be subject to personal capital gains tax at 28% (18% to the extent any gain is within the basic income tax rate band) subject to any other reliefs they can claim. One relief that will be available to all taxpayers who haven’t made other gains in the same tax year will be their annual exemption which currently stands at £10,600 (2011/12). In addition, and provided the company is a trading company (not for example a property investment company or a trading company with significant nontrading assets) and the winding-up of the company takes place within three years of the date that trading ceases, it may be possible for the shareholder to claim a 10% CGT rate. This is available up to a lifetime maximum of £10 million of gains to an individual who in the twelve months prior to the date that trading ceased had at least a 5% interest in the ordinary share capital and voting rights and was an officer or employee of the company.
Complex anti-avoidance provisions are available to HM Revenue in circumstances where the reason for the winding-up is not commercially based but in fact, represents a means of tax-effective profit extraction in continuing business. If these provisions were to apply the distribution to the shareholder would normally be taxed as income and thus the benefits of capital gains tax treatment would be lost. It is therefore necessary to have valid and predominant commercial reasons for the disincorporation to avoid the effect of these provisions. In cases where large sums are involved, or where the shareholders want some certainty as to their tax position, it is possible to seek in advance clearance from HM Revenue that, given the circumstances of the case in question, the anti-avoidance rules will not be used. To successfully obtain such a clearance it will be necessary to demonstrate that the disincorporation is commercially driven. Clearance will not be forthcoming in circumstances where one company replaces another and the shareholders are simply attempting to extract value from the first company at reduced capital gains tax rates.
Shares in unquoted trading companies are often exempt from inheritance tax because of “Business Property Relief”. An interest in a sole trade or partnership will often qualify for the same relief. However, there is a minimum ownership period before a taxpayer can qualify for this relief which means that on a disincorporation the business must be carried on for two years before the sole trader‘s or partner’s Estate will be free from exposure to inheritance tax in respect of the value of the business or a share in a business. If the individual in question is in reasonable health and not too old, it may well be possible to obtain short term insurance cover at reasonable rates to protect against this potential liability.
As will be seen from the above, there are a number of tax and other complications when an attempt is made to disincorporate anything but the simplest of companies. It will often be very difficult, if not impossible, to avoid significant tax charges but this will depend upon the individual circumstances and a careful evaluation of the issues outlined above will enable a proper review to be undertaken. It may be that the commercial advantages of disincorporation will have to be signed before any overall advantage can be obtained given the difficulties outlined but this should not deter businesses from considering and reviewing this option.