Many individuals, either on their own account or in partnership, consider, from time to time, transferring the business to a limited company. In most cases, careful thought will be required to consider the advantages or disadvantages of doing so. Even when the decision to transfer the partnership to a limited company or incorporate it proceeds, important issues need to be addressed to ensure that the incorporation is tax-effective. A few of these are discussed below.
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Advantages/Disadvantages of Incorporation
There are a number of practical and commercial reasons why incorporation is sometimes attractive. Many people find it easier to regulate their businesses by transferring assets from a sole proprietorship to a limited company. Rather than the vaguer collection of rights and duties that constitute a partnership. In some markets, the perceived status that goes with trading as a limited company is important. In certain circumstances, the limited liability status that companies may offer is an important consideration.
Advantages
A business interest that is represented by shares can be transferred simply. Ease succession and inheritance tax planning if the intention is to transfer an interest in the business to family members. However, automatic annual tax savings were available to very small businesses. When incorporated a few years ago,, have mostly now been eroded by changes in legislation, but for high earners. Especially those with potential income above the £100,000 threshold at which personal allowances are lost or the £150,000 threshold at which a 50% income tax rate commences. The savings can be considered in the right circumstances.
Transferring from sole trader to a limited company also provides a more flexible arrangement. Incorporation offers more tax planning options depending upon the levels of profit. Also on the individual circumstances of the directors/shareholders. In particular, the ability to take tax dividends from company profits, free of any national insurance liability, can be very attractive. As can the reduced levels of taxation applied to profits retained (broadly up to £300,000 p.a.) in a company (currently 20%) compared to income tax rates (up to 50% from 6 April 2010) plus Class 4 National Insurance of 9% on profits of between £7,225 and £42,475 and thereafter at 2%.
Furthermore, where the annual salary is drawn by a director/shareholder in a limited company is low (say £5,500 to £7,500). Then whilst the resultant Class 1 National Insurance contributions are nil or negligible. Credit is given for state retirement benefit calculations as if earnings were £14,400 (2011/12). This is in contrast to Class 4 National Insurance contributions (percentage of profits) paid by the self-employed. which gives no state benefit entitlement and Class 2 National Insurance contributions (flat-rate weekly payment) which only give the basic entitlement with no Second State pension benefit.
Disadvantage
Against the above, it needs to be borne in mind that transferring from sole trader to limited company will increase. The regulatory burden on the business proprietor probably leads to an increase in legal and professional fees of running the business. Impose a new set of duties and responsibilities on the trader in their new role as a company director which cannot be taken lightly. In particular, consideration will need to be given to the National Minimum Wage regulations. Whether they apply to each company director (which is dependent upon whether the director is just an officer or an officer and employee).
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Tax Planning Issues on Incorporation
Fundamentally incorporation consists of the transfer of a parcel of business assets (including goodwill) to a company. These transferring assets from sole trader to limited company have tax implications which are considered in more detail below. In the first instance, however, the trader must decide which assets they actually want the company to own. Whether there are some assets they would rather keep outside the company.
In particular, if the business premises are owned by the trader. It will usually be advised not to transfer these into a limited company as there may be long term capital gains tax disadvantages in doing so. This is because on any subsequent sale of the property by a company. There may be a double tax charge where the company has to pay corporation tax on any gain made on the sale. But the directors/shareholders then have to pay personal tax as well in order to extract the relevant funds from the company.
If the decision is made not to put a building into the company. Then the next decision is whether the company pays rent to the director(s) for making that building available for trade activities. This is usually advantageous because the (taxable) income received by the director(s) is free of national insurance contributions. Whilst the company gets a full deduction against corporation tax for that cost.
Capital Gain Tax Rate in Incorporation
There may be a long-term disadvantage if the property is ever sold in conjunction with a sale of the company’s shares. In such circumstances, it is possible to obtain a 10% capital gains tax rate on up to £10 million (per individual). It is the combined gain on the sale of the shares and the business premises. This compares with the normal capital gains tax rate of 28% (18% where gains fall within the basic income tax rate band).
However, this reduced 10% rate can be lost in respect of the gain on a property. In circumstances where rent has been received from the company. Detailed advice will, therefore, be required on what the consequences of charging rent in these circumstances might be as the rules are far from straightforward. At the end of the day, the director(s) will have to take a view on whether it is worth foregoing the current advantages of receiving a rent against a possible long term capital gains tax disadvantage (bearing in mind that there is a £10m cap on the 10% rate, as indicated above, and that a business purchaser may not always want to acquire the building in question).
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Goodwill
Incorporation will entail a transfer of the business goodwill to the limited company. This transfer is treated as taking place at market value for tax purposes. Although if nothing is actually paid for goodwill by the company. It is usually possible for an election to be completed to avoid any immediate capital gains tax implications of incorporation liability on this transfer.
Many traders prefer to sell their goodwill to the company at full value. Even though this may involve some capital gains tax liability particularly if the rate is only 10%. Once this liability has been accounted for. It should be possible for the company to pay for the goodwill out of future profits in time with no further tax liability. Expert advice will be required both to establish the value of the goodwill and to ascertain whether there is in fact “free goodwill” within the business that can be sold in this way. HM Revenue does not accept that all types of goodwill are necessarily transferable at a value to a company, depending upon the type of business. Also, tax disadvantages can arise if the value of goodwill is overestimated. Although with professional advice this risk can be mitigated.
Provided that the original pre-incorporation business was set up on or after 1 April 2002. The company can write off the purchase cost of the goodwill against its taxable profits over a reasonable period of time. (based on the anticipated economic life of the goodwill) and obtain tax relief accordingly. However, whether a tax deduction is available or not. The amortization of goodwill will reduce the annual profits of the company available for distribution by way of dividends. This may restrict this useful form of tax-effective profit extraction.
VAT
VAT does not usually have to be charged on the transfer of sole trader to a limited company. Indeed there is a procedure by which the VAT number itself can be transferred if desired (subject to certain conditions. In particular, that any VAT liabilities become an obligation of the transferee if not settled by the transferor).
Conclusion
The decision to transfer a business to a limited company or partnership to a limited company might be easily taken. But it should be very carefully implemented so that all the above points, and others where relevant. They are taken into account and dealt with in a way that creates no future tax difficulties. Maximizes tax planning opportunities. It should also be remembered that there are a number of statutory tax reliefs to smooth the process of incorporation. The same cannot be said for disincorporation which is a much more difficult process. The incorporation of a business should not, therefore, be undertaken without careful consideration of all the relevant issues.
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