Many individuals who are self-employed, either on their own account or in partnership, will from time to time consider whether it might be to their advantage to operate as a limited company (usually referred to as “incorporation”). In most cases careful thought will be required to consider the advantages or disadvantages of this step and even when the decision to proceed with incorporation has been made, important issues need to be addressed to ensure that the incorporation is tax effective. Some of these are reviewed below.
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 business relationship through the medium of a limited company rather than the vaguer collection of rights and duties which constitute a partnership. In some markets the perceived status that goes with trading as a limited company is important and in certain circumstances the limited liability status which companies may offer is an important consideration. A business interest which is represented by shares can be transferred simply and thus ease succession and inheritance tax planning if it is intended to transfer an interest in the business to other members of the family. However, the automatic annual tax savings that 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 and/or the £150,000 threshold at which the 50% income tax rate commences, the savings can be considerable in the right circumstances.
Incorporation also provides a more flexible arrangement and offers more tax planning options depending upon the levels of profit and 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 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 give 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.
Against the above it needs to be borne in mind that transferring a business to a limited company will increase the regulatory burden on the business proprietor, probably lead to an increase in the legal and professional fees of running the business and impose a new set of duties and responsibilities on the trader in the 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 and whether they apply to each company director (which is dependent upon whether the director is just an officer or an officer and employee).
Tax Planning Issues on Incorporation
Fundamentally an incorporation consists of the transfer of a parcel of business assets (including goodwill) to a company. These transfers 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 and 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 advisable 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 should pay a rent to the director(s) for making that building available for its use in carrying on the trade. 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. However, 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 may be possible to obtain a 10% capital gains tax rate on up to £10 million (per individual) of 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 these circumstances where a rent has been received from the company. Detailed advice will therefore be required on what the consequences of charging a 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).
An incorporation will entail a transfer of the business goodwill to the 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 liability on this transfer. Many traders will however 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 in due course for the company to pay for the goodwill out of future profits 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 do not accept that all types of goodwill are necessarily transferable at value to a company, depending upon the type of business. Also tax disadvantages can arise if the value of goodwill is over estimated 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 will be able to 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 amortisation of goodwill will reduce the annual profits of the company available for distribution by way of dividends and thus may restrict this useful form of tax effective profit extraction.
VAT does not usually have to be charged on the transfer of a business to a limited company and 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).
The decision to incorporate a business might be easily taken but it should be very carefully implemented so that all the above points, and others where relevant, are taken into account and dealt with in a way that creates no future tax difficulties and maximises tax planning opportunities. It should also be remembered that whilst 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.