Incorporation

Incorporation remains a popular option for businesses and the difference in the tax treatment of incorporated and unincorporated entities can be a key driver in this. More specifically, the following factors may all affect the decision of whether or not to incorporate:

• steadily increasing rates of Class 1 NIC for employers and employees;
• much lower (and reducing further) corporation tax rates compared to personal tax rates; particularly with the advent of the 50% top rate of income tax;
• the ability to shelter profits in the limited company;
• no further tax payable if the dividend falls to be taxed at below the higher rate tax threshold;
• lower effective tax rates of tax for dividends falling to be taxed at the higher and additional rates of tax
• the transfer of a business to a company is a chargeable event for capital gains tax purposes and because the company will be connected, any chargeable transfers are deemed to be made at market value at the date of transfer.

There are, however, two important alternative reliefs from capital gains tax:

1. Incorporation relief Under TCGA 1992, s162

This relief is available where an unincorporated trader transfers to a company a business as a going concern, together with the whole of the assets of the business (or the whole of the assets other than cash) and the transfer is made wholly or partly in exchange for shares issued by the company to the transferor. The chargeable gain on the disposal of the old assets is deferred by holding over the gain against the base cost of the shares in the new entity. The relief applies automatically if relevant criteria are met but may be disapplied.

2. Hold-over relief Under TCGA 1992, s165

As an alternative to Incorporation Business asset hold-over relief may instead be claimed. This has the advantage that the whole of the business does not need to be transferred and, if desired, certain assets may be kept outside of the company. The held-over gain is then set-off against the base cost of the relevant assets within the company. It is sometimes the case that a property will be kept outside of the newly-incorporated company and for the company to pay a rent for the property. This will have certain tax advantages but you should be aware that this can mean that the owner will lose entitlement to Entrepreneurs’ Relief on the property, as the property would now be regarded as an investment property.

Goodwill is a chargeable asset for capital gains purposes and should be given close attention when considering an incorporation.

A popular tax planning strategy has been for a trader to disapply incorporation relief and hold-over relief and for the newly-formed company to pay for the goodwill, normally by crediting the director’s loan account in the new company. This often means that the trader will take a capital gains tax 'hit' on incorporation and in doing so, the trader will crystallise a capital gain which will, provided that the relevant conditions are met, qualify for entrepreneurs’ relief and be taxed at 10%. The director will then be left with a balance on director’s loan account from which he may draw down tax-free.

If goodwill is acquired by the newly-formed company on incorporation for consideration, the amortisation of goodwill in the company may be eligible for corporation tax relief under the corporate intangible fixed asset regime under Corporation Tax Act 2009, Part 8. It should be noted that this will normally only be possible where the unincorporated business commenced on or after 1 April 2002.

When transferring goodwill on incorporation, care should be taken in valuing the goodwill. The valuation of goodwill should take into account factors attaching to the business, eg client base, contracts and order book but should not include 'personal' goodwill, ie goodwill that is specific to the trader. The test should be 'How much would the goodwill of the business be worth if the proprietor was to walk away from the business?'

In cases where a business is incorporated and goodwill is transferred to a connected company, HMRC will always refer the valuation to their Shares and Asset Valuation division.

When transferring a property to a company on incorporation, don’t forget SDLT.

The general rule for stamp duty is no consideration; no SDLT.

However, FA 2003, s 53 contains a nasty SDLT trap on the gift of a property into connected company. If an individual gifts a property into a company that he controls, the company will incur an SDLT bill, payable 30 days after the property is transferred.

The company is deemed to have paid the market value for the property (for stamp duty purposes). even though they never paid a penny and so SDLT is payable on the full market value of the property.

A decision will need to be made as to whether to transfer any property into the company on incorporation, or keep the property outside the company. The following factors need to be considered:

• avoids a charge to SDLT;
• a full commercial rent may be charged to the company; tax deductible for the company; NIC-free in the hands of the owner;
• disadvantages of keeping the property outside the company;
• entrepreneurs Relief will not be available on the property as HMRC will regard it as an investment property;
• only 50% business property relief for inheritance tax purposes, rather than 100%.

Incorporating a business can still have significant tax advantages but what may be right for certain businesses may not necessarily be appropriate for another business so each case should always be looked at on its own merits but the potential for substantial savings remains.