There are a number of issues that should be reviewed before incorporating a business. For illustration purposes, only trading partnerships (rather than a sole trade) have been referred to in this article. It is important to consider anti-avoidance legislation prior to implementing any planning strategy.

Section 162, section 165 and outright sale

Capital Gains Tax (CGT) is a significant factor in any incorporation. The disposal of a business to a company is considered a connected party transaction, and any disposal proceeds from chargeable assets will be deemed to be made at market value.

TCGA section 162 incorporation relief can be used to transfer a partnership’s business without materialising CGT on the transfer. The gain is rolled into the base cost of the shares being received by the new company in exchange for the assets. The assets attract a market value uplift on transfer into the company.

Section 162 is restrictive because all assets (with few exceptions) must be transferred. Withdrawal of assets prior to incorporation may have merit.

TCGA section 165 gift relief is used to transfer chargeable assets to the company at undervalue, with the gain held over against the base cost of the asset. The advantage of section 165 is that the business owners can choose which assets are transferred.

Sale of chargeable assets to the company in return for an IOU debt owed to the directors can be beneficial. CGT will be payable at 18%/28%. If entrepreneurs’ relief (ER) is available, the rate reduces to 10%. The sale of chargeable assets (e.g. goodwill and property) to a business, and payment of CGT can assist with a favourable future remuneration structure.

Goodwill

HMRC regard there to be three types of goodwill to be found in a business, but only ‘free’ goodwill (that which is inseparable from the business, generated by reputation and name) is transferable on incorporation. Selling goodwill to the company can be an efficient way of director/shareholder (DSH) extracting income, by capitalising the goodwill and creating an IOU debt.

Goodwill is amortised in the accounts. Under the intangible fixed assets regime the amortisation is a tax-deductible expense where it has been created or acquired from an unrelated third party after 31 March 2002. Related parties include participators in close companies. Therefore, it is unlikely that tax-deductible amortisation will materialise where the partners are DSHs at acquisition by the company. Relief may be available where goodwill has been purchased externally from 1 April 2002, e.g. purchase of another business.

Remuneration planning

Partners may have to establish a drawings policy so funds are retained within the business for working capital. In a partnership, profits are subject to income tax and national insurance (NIC), irrespective of the cash available to draw. Some partners will be paying a marginal tax rate of 47%.

By comparison, the corporation tax (CT) rates are currently 20% for small, and 21% for large companies. The DSHs will however require an income which of course is taxable on them personally.

Salary and Dividends – DSHs below state pension age should consider extraction of a salary of at least the NIC Lower Earnings limit to ensure NIC contributory requirements are met. If further income is needed, a dividend (subject to reserves) may be appropriate. It may also be worth consideration of waivers and different share classes where DSHs have different income requirements but this is complex and higher risk.

Directors Current Account (DCA) – Where goodwill has been sold in exchange for an IOU from the company a capital gain is crystallised. The balance is available for drawings, depending on cash flow.

In the example below, the business profits are £1,000,000 per annum, with four equal owners. Goodwill is valued at £3,000,000 and net drawings (after tax) are restricted to £7,500 per month, per partner:

Example

	Unincorporated Business £	Incorporated (s162, s165) £	Incorporated (goodwill sale) £
Business
Profits of business (adjusted for salary) (1)	1,000,000	968,320	968,320
Income Tax National Insurance Corporation Tax	394,508 29,432	89,153 202,018	202,018
Annual taxes	423,940	291,171	202,018
Individual
Partnership
Profit (restricted drawings, after tax) (2)	90,000
Company
Salary		7,920	7,920
Dividend (net)		104,368	30,500
Less: additional tax due		(22,288)	(NIL)
IOU drawing			51,580
Net cash per owner	90,000	90,000	90,000
CGT payable (in total) (3)			£300,000
(1) Company profits have been adjusted for director salaries
(2) Partnership: net cash after tax is £144,015 per partner, but only £7,500 per month is available for drawing, so this is limited to £90,000
(3) Capital gains tax is payable on the value of the goodwill. CCT is payable on 31 January following the end of the tax year of incorporation. 10% CGT rate (ER qualifying) is assumed

Once the IOU is exhausted, the DSHs will require higher dividends, but still attract a significant tax deferment, based on drawing limitations of £90,000 per annum.

Profits in a company do not belong to the DSHs until distributed. Therefore, the double taxation impact should be reviewed for DSH extraction. It may be possible to structure a future retirement plan withdrawal through a Company Purchase of Own Shares CGT transaction, which can be arranged without consideration of market value. If ER is available, 10% tax is payable. A DSH’s shares could also be converted to a different class on retirement and smaller distributions made within the basic rate tax band.

Benefits in kind (BIK)

A partnership car purchase attracts capital allowances (CAs) based on CO₂ emissions. The CAs and running costs are then adjusted for private use, before taxes are calculated.

Car purchases and expenses via a company are wholly allowable for CT. However, where there is private use by the DSHs (including family members), a BIK will arise and result in income tax payable by the DSHs. Class 1A NIC is payable by the company. Consider whether cars or other high benefit assets should be removed prior to incorporation.

Capital allowances

On incorporation, assets in the CA regime are deemed to be sold to the company for market value. The ‘market value’ rule applies as the partners and company are connected persons. The disposal of the assets to the company will create balancing adjustments where there is a difference between the market value and the CAs tax written down value on incorporation. To avoid balancing adjustments, a joint election to transfer the assets at their tax written down value can be made.

The partnership will not be entitled to capital allowances for the period of account in which the incorporation takes place. Consider whether there are any upcoming significant purchases which would attract high CAs. A short period of account prior to the final period to incorporation may be beneficial.

Pensions

As the DSHs’ relevant income will have reduced to a minimal salary, contributions to pensions should also be reviewed as a tax charge arises if contribution limits have been exceeded. If employer contributions are made, there is an opportunity to increase contributions to the annual limit (currently £40,000, with potential utilisation of the previous three years’ limits, providing a qualifying scheme is in place) and obtain CT relief, providing the contributions qualify as wholly and exclusively for the purpose of the trade.

Property

Commercial property is often another valuable asset owned by partnerships, or by partners personally.

If s162 is used, the property must be transferred if it is on the balance sheet at incorporation. In other scenarios, whether a property should be transferred will depend on the individual facts.

The sale of the property to the Company in return for a further IOU (net of attached loans), and paying 10% CGT on the gain may be advantageous.

Stamp Duty Land Tax (SDLT) is payable on the transfer where the transferor and transferee are connected. If the property is worth less than £150,000 then the SDLT rate is 0%. For higher value property, complex legislation for SDLT and partnerships should be reviewed where there is no alteration of the ownership of the property on incorporation, as transfers may still be possible at 0%.

Commercial property can also be sold to the partners’ pension scheme at a 10% CGT rate (under the ER associated disposal rules), then subsequently leased back to the company at market rent. The rental income generated within the pension scheme is tax-free, and is a tax-deductible expense for the company. However, be aware of the creation of new leases and their SDLT implications. An in-specie contribution of the property itself prior to incorporation (when relevant earnings are higher) may also be feasible.

Alternatively, the partners may hold the property personally. Any market rent payable affects future ER available on the sale of the property. Business Property Relief (BPR) may also be affected for inheritance tax purposes as the asset is not owned in the trading company.

VAT

Where assets are transferred as a going concern and the same type of business is being carried on, the going concern provisions should apply and VAT would not be payable on the transfer.

There is an exception to this rule where the incorporation ‘transfers’ include land or buildings in respect of which the transferor has exercised the option to tax. In these circumstances, the transferor is required to charge VAT at the standard rate unless the transferee has made a valid option to tax the relevant property before the transfer takes place.

The VAT records of the original business are normally transferred to the new company and it is also possible for the registration number to be transferred. If the business wishes to transfer the partnership’s VAT registration number, a joint application must be made on form VAT 68.

Employment related securities (ERS)

ERS legislation is complex in relation to the tax treatment of shares and securities (subject to restrictions) that are made available by way of an individual’s employment. Where a new shareholder is introduced to the company, there is potential exposure to income tax on the difference between the market value of the shares and the price paid.

In order to avoid a charge under ERS legislation, the shareholder could agree to pay market value for the shares using a partly paid share scheme. The amount unpaid is then treated as a notional loan which is potentially chargeable as a BIK. It may be possible to obtain a BIK exemption on the basis of a loan for qualifying purposes.

Inheritance tax

The balance on a director’s DCA does not attract BPR. It may be possible to convert some of the debt to a form of preference share and take advantage of the inheritance tax replacement business property legislation, but even this has its problems, such as management of encashment and replenishing the DCAs.

There are also issues where there is a provision for other shareholders to purchase shares on death of a shareholder. The use of cross-option agreements should help to avoid this issue.

Whilst there are a number of tax issues and pitfalls which should be considered, and more planning opportunities than can be detailed within this article, it is also important that clients are aware of their administrative and legal responsibilities when operating through a company.

Sherena Deveney is a Chartered Tax Adviser with BDO Northern Ireland.

Email: sherena.deveney@bdo.co.uk