At first glance the decision to incorporate may appear to be a fairly straightforward one, particularly when you consider the lower tax rate for corporates of 12.5%. However, the decision requires careful consideration and each case needs to be examined on its facts.

There are a number of tax issues that need to be considered when incorporating your business. These can be examined under the key tax heads of; income tax, corporation tax, capital gains tax, stamp duty and value added tax. I will now consider each of these in turn.

Income Tax

Drawings

One of the main issues to consider when deciding whether or not to incorporate, is the level of drawings of the owner. Unless the drawings of the owner are significantly less than the profits of the business, the use of a company will not provide any tax advantage, as all profits will ultimately be subject to income tax.

Timing of Incorporation

Where a sole trader decides to incorporate, they will cease their sole trade business and the income tax “cessation provisions” will apply. The date of cessation will determine whether an additional income tax liability will arise for a business using an accounting date other than 31 December. Choosing the most beneficial cessation date may result in significant tax savings.

Losses

Unfortunately, the losses of the business cannot be transferred to a company. Where the business is loss making, it may be more beneficial to carry on the business as a sole trader. Such trade losses can be offset against an individual's total income of the year. Where any part of the losses cannot be set against other income of that year, these losses can be carried forward and set against future trade income.

Where it is not possible to utilise all business losses, or where the business is expected to remain loss making, it may be more beneficial to wait until the business becomes profitable, and uses up the losses carried forward, before incorporation.

Balancing Allowances/Charges

The transfer of plant & machinery, etc., from a sole trader to a company may trigger a balancing allowance/balancing charge, as the assets will cease to be used for the purposes of the business of the sole trader. These assets will be deemed to be transferred at their market value, as both parties are connected for tax purposes.

However, both the individual and the company may jointly elect to have these assets transferred at their tax written down value (“TWDV”), which avoids any balancing charge or allowance arising on the transfer of the assets.

Stocks

Where stocks are transferred to the company, the value placed on the stocks should be the open market price. If this value is higher than both the cost of the stock and the price being paid for the stock, both parties can jointly elect to transfer the stock at the lower of cost or price being paid on transfer. This is to ensure that no artificial loss can be created by the sole trader on a transfer of stock.

Corporation Tax

Start-Up Exemption

A common misconception is that the tax exemption available to start-up companies applies to all new companies. Unfortunately, this is not the case. The relief is only available where a new company is incorporated to undertake a new trade. This exemption will therefore not be available where the trade was previously carried on by a sole trader, and is transferred to a company.

Loan to Company

Where an individual decides to incorporate a business, and an initial investment is required in the company, it may be more tax advantageous to make such investment by way of a loan to the company rather than by investing in share capital in the company.

A loan can be repaid tax-free by the company. However, where an individual invests in share capital, any monies to be “repaid” to the individual would probably have to be taken out either by way of salary or dividend, both of which would be liable to income taxes.

Pension

The tax relief which an individual can claim for premiums paid to a personal pension plan is capped by reference to a fixed percentage of income. Such percentage can range from 15% to 40% depending on age. In addition there is also an overall earnings cap of €115,000 for 2011.

These limits do not apply to a pension scheme established by a company. Through careful planning, it may be possible to make tax deductible pension contributions in line with (and in some cases greater than) the salary of the owners. This can be particularly tax effective where an individual has a shortfall in their pension fund or is getting close to retirement.

Close Company Surcharge

Where an individual transfers a business to a company, this company will likely be a close company for corporation tax purposes. If the company is regarded as a service company, that is a company whose business consists of the carrying on of professional services, it may be subject to a surcharge of 15% on part of its undistributed profits. A company, other than a service company, may be liable to a 20% surcharge on part of its undistributed interest, rental income or dividend income. These surcharges can be avoided where all profits arising are paid out by the company by means such as additional salary, pension contributions or dividends. However, these surcharges are a negative consequence of building up of reserves in the company.

Termination payments

The company will be able to make tax efficient termination payments to the owners when they retire from the company. Similar such tax efficient payments cannot be made when operating as a sole trader.

Capital Gains Tax (“CGT”)

A sole trader and a company are separate legal entities, thus the transfer of business assets to a company may give rise to CGT.

The assets will be deemed to be transferred at their current market value. Where the market values of say property and goodwill, exceeds the allowable cost, a taxable gain will arise, giving rise to a CGT liability. This CGT liability could arise even though no actual cash proceeds are received for the business.

Section 600 TCA 1997 provides for relief from CGT where an individual transfers all of the assets of the business, or all the assets other than cash to a company, in exchange for shares in the company. To qualify for the relief the transfer must be for bona fide commercial reasons and not form part of a tax avoidance scheme.

The extent to which the relief is available depends upon whether the assets are transferred wholly or partly for shares. No CGT will be payable at the time of the transfer where the only consideration received is shares in the new company, but a CGT liability may arise if other consideration is received. In this regard, it should be noted that in certain cases the transfer of creditor balances to the company will be regarded as consideration for the sale of the business, and may thus give rise to a CGT liability.

The effect of this relief is to defer all or part of the CGT arising on the transfer of the business until such time as the company i.e. the shares is ultimately sold.

Whilst the above relief can be attractive, consideration needs to be given as to whether all the assets, particularly property, should be transferred to the company. Whilst a transfer of the property may give rise to an initial CGT saving by availing of the relief under section 600 TCA 1997, such transfer of the property may give rise to a double tax charge in the future – a CGT charge on a disposal of the property, and a second tax charge on getting these proceeds back to the individual.

Having considered the tax issues, you should also consider whether there are any commercial reasons why it would be more beneficial to hold the property in a company. Perhaps it would be more efficient to repay any property loans through a company, as the company should have higher post tax profits when compared to a sole trader.

Stamp Duty

The transfer of assets to a company may be chargeable to stamp duty at rates of up to 6% depending on the assets transferred and their values. Generally the assets that will be transferred include: property, plant & machinery, stocks, debtors, cash and possibly goodwill.

With regard to property, for any transfer to be legally binding, it must be in writing and will therefore be subject to stamp duty.

No stamp duty arises where assets are transferred by delivery. Thus it may be possible to transfer plant & machinery, stocks and current account bank balances without any stamp duty arising.

Where debtors are assigned to the company, a stamp duty liability may arise based on the gross value of the debtors. To avoid such liability, the company could be appointed collection agent for the sole trader, with the proceeds being used to pay off the liabilities of the sole trader.

Where the consideration for the transfer of the business is shares in a company, the stamp duty planning options are restricted. Under section 58(2) Companies Act 1963, an Irish company is required to file any written contract (or a written memorandum if there is no written contract), that involves the issue of shares for non cash consideration. The Irish tax authorities consider that such a document is subject to stamp duty.

Also, any instrument that effects the transfer of debts to a company may also be subject to stamp duty.

Value Added Tax (“VAT”)

VAT may arise on the transfer of assets from a sole trader to a company. However, under section 20 Value-Added Tax Consolidation Act 2010, VAT is not chargeable on the transfer of assets made in connection with the transfer of a business, provided both the purchaser and vendor are VAT registered, and the business being transferred can be operated on an independent basis.

This relief would normally apply where a business is transferred from a sole trader to a company.

Conclusion

Incorporating your business will give rise to a number of tax issues, which require consideration. In addition to the tax issues outlined in this article there are also non tax issues to be considered such as the additional compliance costs and filing requirements that apply for a company.

Where this decision is made to incorporate, great care must be taken in deciding what assets to transfer and in drafting the appropriate documentation, to ensure all potential tax liabilities are minimised.

Michael Smith is a Director with FS Taxation Limited, taxation and accounting consultants.

Email: michael@fstax.ie