Chris Thorpe looks at some issues to be aware of when incorporating a business.
When a sole trader (or even a partnership) wishes to operate through a limited company, they may be doing so for several reasons; tax likely being one of them.
However, as well as the ongoing corporation tax or income tax liabilities, there are tax implications of the incorporation itself.
What is incorporation?
The term ‘incorporation’ refers to transferring a business into a limited company – a separate legal entity, a body corporate. A partnership can incorporate into a limited liability partnership (LLP), which is also a body corporate, but there are no tax consequences in doing so.
Transferring a business from a sole trader or a partnership to a limited company, however, does have tax consequences.
What are the tax consequences?
As the assets of the business are being transferred into the ownership of another legal entity, there is a disposal by the sole trader or partner for capital gains tax (CGT) purposes. The most potent tax, however, can be stamp duty land tax (SDLT) (or devolved equivalent in Scotland and Wales) if land or buildings are being transferred, as consideration is deemed to have been given at market value. As this is payable within 14 days of completion, it is a painful ‘dry’ tax charge. So how can these consequences be addressed?
The capital gain is rolled over against the company’s shares by virtue of incorporation relief (TCGA 1992, s 162). There are two unusual aspects of this relief. First, it is automatic – provided all assets of the business are being transferred (except cash) the relief takes effect, but it can be disapplied. Second, it only requires a ‘business’ to be transferred, whereas other CGT reliefs require the activities to be a ‘trade, profession or vocation’. A ‘business’ being wider than a ‘trade’ would allow investment-type activities to be incorporated as long as they’re run on a commercial basis. Incorporation relief is often disclaimed, and instead, the CGT is paid. A credited director’s loan account represents the proceeds and can be drawn down tax-free once cash is available within the company; with the gains already paid for, this means deferred gains are not left lingering into an uncertain future.
The SDLT can only really be averted completely if land or buildings are left outside the new company – but this can have wider implications such as incorporation relief being unavailable and reliance needing to be placed on ‘holdover relief’ (under TCGA 1992, s 165) to defer the CGT. More importantly, going forward, only 50% business property relief is available for inheritance tax purposes, as opposed to 100% relief, which would be the case with land or buildings being on the company’s balance sheet. The other potential way to avoid SDLT is to incorporate a partnership into a limited company, in which case the partnership SDLT rules (FA 2003, Sch 15) overrides the market value rule (in FA 2003, s 53); provided all the partners become shareholders or are related to each other, the SDLT is effectively at 0%.
What other things to consider?
The main one is simply that the profits no longer belong to the sole trader – they belong to the company. The trader cannot just help themself to cash from the company as they could previously; it needs to be declared as a dividend or paid as a salary (or rent if they have retained any property used by the business).
Practical tip
Think carefully about whether incorporation is the right course of action. Run through different scenarios with varying levels of company profits against director salaries or dividends (those same profits are being taxed twice, remember!) and review the combined corporation and personal tax outcomes. Consider, too, whether all assets will be incorporated or not – land carries SDLT implications, but failure to incorporate all assets will remove CGT incorporation relief (under TCGA 1992, s 162).
