Tax tips: Plan early when incorporating a business to maximise tax relief on goodwill valuation
For businesses operating as partnerships, LLPs or sole traders, there are a number of tax advantages to incorporating into a limited company which can result in a significant reduction in the overall the rates of tax.
The profits of partnerships, LLPs and sole traders are all taxed directly on the business owners according to their rates of income tax, which are often as high as 45%, plus national insurance contributions.
By contrast, companies pay corporation tax on their profits, with directors being remunerated with salaries and benefits in kind, and shareholders able to share in profits through the payment of dividends. Companies having profits of less than £300,000 have been subjected to corporation tax at the rate of 20% since April 2011 (previously 21%), and with effect from April 2015 all companies, irrespective of profit levels, will pay corporation tax at this rate.
Benefits of incorporation
There is an opportunity for a business to be sold for its open market value to a company which has been incorporated by its owners. This value must be agreed with HMRC, and the gain arising on the disposal by the individual business owners will be subject to capital gains tax. As business owners can generally claim entrepreneurs’ relief, this means the rate of tax payable on the gain is likely to be 10%.
The company is of course unlikely to have the funds available to purchase the business immediately, therefore the proceeds of sale will typically be allocated to the owners’ director’s loan account within the company, allowing the funds to become available over time from the company’s ongoing net profits. No further tax liabilities will be incurred by the individuals on the draw-down of these funds.
In addition, the flexibility of being able to shelter profits at the corporation tax rate and plan for tax efficient levels of personal income can provide much more flexibility than the previous self employment structure.
There are further benefits to running a business through a limited company, such as the ability for the company to make pension contributions thus saving on national insurance costs; the ability to claim R&D tax credits where applicable; and the ability to incentivise employees through a tax efficient share scheme, such as the Enterprise Management Incentive; or attract investment from individuals wishing to participate in the Enterprise Investment Scheme (EIS), or SEIS for start up companies.
Finally, there is an added benefit if you incorporate a business which first commenced trading on or after 1st April 2002; in this case the limited company is able to claim corporation tax relief as it writes down the value of the goodwill it has acquired over its useful lifetime.
Rules governing transfer to connected individuals
The incorporation opportunity outlined above involves a transfer of a business to a connected limited company which is owned by the owners of the original business. This incorporation changes the structure of the business and the way in which it operates. Such a sale to a connected party is not regarded by HMRC as a sale in the conventional sense because the original participants of the business remain in control of the new company; this means that the sale price is not governed by open market forces. As a result, it is important to undertake a valuation of the business and to agree this with HMRC.
As is to be expected, HMRC are keen that a value is not placed on such businesses which exceeds the fair market value; in particular, they are keen to ensure that value which attaches to the individuals who own the business; ‘personal goodwill’, is not included in the valuation of the business itself. In order to police this, HMRC have established a new ‘Counter Avoidance Clearance’ office to establish whether the goodwill involved is transferable or personal.
Incorporation cases are passed to this specialist office who will generally then raise queries requesting further information, such as whether a formal business valuation was undertaken by a third party; whether the former business had employees that were also transferred to work for the new company during incorporation; and the type of work they undertake. This is specifically aimed at establishing the element of goodwill that is personal to individuals and should not therefore have a value attached to it.
Queries from HMRC concerning the value attached to goodwill are commonplace and have been so for some time; however the new specialist office is taking these enquiries further with additional questions to establish whether a true incorporation of the business has taken place, such as requests for work contracts or purchase orders from suppliers before and after incorporation; communication with customers, employees and other stakeholders to demonstrate that an incorporation is taking place; changes to VAT and PAYE registrations; evidence of professional insurance covering the date of incorporation; and bank records showing evidence of new payment details.
If you wish to consider incorporating your business, there are a number of alternative ways of doing this and it is essential that advice is taken early in the process to ascertain the best approach and to ensure the necessary correct steps are taken.
For specialist advice on incorporating a business into a limited company structure, contact Lesley Stalker by emailing firstname.lastname@example.org.