Beneficial incorporation: A case study

Ken Moody looks at a case study to illustrate that incorporating a business can be beneficial from a tax perspective in some cases.  

When considering the incorporation of a business it is worth weighing the ‘pros’ and ‘cons’ of each alternative in order to conclude which is the optimum route in the particular circumstances. Sometimes the result is surprising.  

There are two routes to incorporation of a business for capital gains tax (CGT) purposes: using ‘incorporation relief’ under TCGA 1992, s 162 or ‘gift relief’ under TCGA 1992, s 165. Relief may be restricted under either section where cash extraction is part of the strategy. The following case study involves a partial claim for gift relief on incorporation of a pharmacy business.  

The ‘gift relief’ route 

Where the  ‘gift relief’ route is used, the CGT cost of the shares in the company will usually be nominal, while the gain on the disposal of chargeable assets is held over against the value of those assets, so in effect the company inherits the transferor’s base costs. However, the gain which may be held over is restricted where there is actual consideration and the amount apportioned to chargeable assets exceeds their CGT base costs, as illustrated below. 

A further factor in the mix is that goodwill transferred to a close company is not a ‘relevant asset’ for the purposes of CGT business asset disposal relief (previously entrepreneurs’ relief), with only minor exceptions. That is not to say, however, that incorporation cannot be tax-efficient in many situations, as illustrated below.   

Case study: Incorporation of a pharmacy business 

A sole-trader pharmacist’s business holds the following assets:   

The goodwill cost £1,300,000 and has been amortised at 10% for nine years, though is currently professionally valued at £2,000,000. On paper the business is worth £600,000, but if the market value of goodwill is factored in, the net asset value is almost £2.5 million. The only chargeable assets are fixed assets valued at book value and goodwill. The gain on disposal of goodwill is £700,000. The business could be sold to the company for full market value but it is not considered commercially acceptable to reduce the net assets in the company to nil, so the sale price is reduced to £2,200,000, apportioned between net assets other than goodwill at their book values of £470,000 and goodwill at £1,730,000.  

For ‘gift relief’ purposes, where there is actual consideration the held-over gain is the amount by which the ‘unrelieved gain’ exceeds the gain by reference to the actual consideration. The unrelieved gain is £700,000 but the gain by reference to the actual consideration is £1,730,000 - £1,300,000 = £430,000. The held-over gain is therefore £700,000 - £430,000 = £270,000. 

The CGT payable is therefore: 

The company will acquire the goodwill net of the held-over gain £2,000,000 – £270,000 = £1,730,000 as its base cost for tax purposes.  

For a relatively modest amount of CGT payable of £86,000, proceeds of £2,200,000 are credited to the director’s loan account and may be withdrawn tax-free, generally in preference to remuneration or dividends liable to income tax and, in the case of the former, employee’s and employer’s National Insurance contributions (NICs); although see below. 

Practical tip 

The director should draw a salary of between £8,788 and £12,500, the optimum position depending upon whether the employer’s allowance for NICs purposes is available. It is also generally advisable to draw dividends up to the income tax basic rate limit of £37,500 (after the personal allowance of £12,500), which only attracts the lower dividend rate at 7.5%.