Lots of entrepreneurs start their business as a sole trader or as a partnership. Later, many decide that it is time to run their business through a company instead. As we mentioned last year the tax benefits of running a company will have often been a major reason for the incorporation of a business.
But now in a world where Entrepreneurs’ Relief is not due and goodwill can’t be written-off for tax, are there still tax efficient ways to incorporate your business?
As background, let’s just to recap the way incorporation's have been done for many years.
Sale for cash
Until December 2014 the most popular method was to transfer the trade to a company by way of sale. As this involved the sale of an asset it would create a capital gains tax charge on the individual or partners selling their trade to a company. But, because the sale of a trade is a disposal of a business asset the gain would be taxed at the 10% entrepreneurs’ relief (ER) rate effectively capitalising future profits of the company for the owner to withdraw, tax paid.
In addition the goodwill included within the business assets sold would be amortised in the company’s accounts over, say, five years generating a tax deduction for the company.
So what changed?
These tax breaks were closed down by the Chancellor’s Autumn Statement in December 2014. Firstly, the capital gain relating to the goodwill sold to the company no longer qualifies for ER for transactions on or after 3 December 2014, so the tax charge will now be at the full 18% or 28% rate for basic or higher-rate taxpayers respectively.
Secondly, the tax deduction for acquired goodwill on incorporation's was also abolished, so there is no longer tax deduction for the amortised goodwill.
As a result, this method of incorporation is no longer attractive in most cases. It’s important not to discount it completely, however, as good results may be obtained in the now relatively rare cases where the gains arise on assets other than goodwill, or the goodwill that can be transferred is relatively modest. For example where the majority of the value of goodwill relates to the owner’s personal skills and can’t be sold to the company.
What can we do now?
Before the favourable capital gains tax rates came in using Entrepreneurs’ Relief and its predecessor Business Asset Taper Relief, most incorporation's used one of two special tax reliefs:
- Incorporation relief; and
- Gift of business assets relief.
With the loss of Entrepreneurs’ Relief both of these methods are likely to come back into fashion.
Incorporation relief
The main method for incorporation of a business will probably now be the so-called incorporation relief using Section 162 of the Taxation of Chargeable Gains Act 1992. Put simply, the business is transferred to a company and the company issues shares to the transferor's to the value of the business transferred. The capital gain is effectively “rolled” into the shares issued.
Unlike Entrepreneurs’ Relief this relief applies to the transfer of any business, it does not have to amount to a trade, so it can be used for incorporation's of property investment portfolios, for example, as well as of trades.
However, this method of incorporation does have some drawbacks:
The relief only applies if a business is transferred as a whole, as a going concern and with all of its assets (except cash).
The business may have assets that the transferor does not wish to transfer into the company, which will have to be extracted. For example, you might want to transfer cars from the business before incorporation. This may be difficult where the asset is, say, the business premises - can this be extracted from the business before incorporation? The costs of trying to extract these assets from the business may outweigh the benefits of using incorporation relief.
Also, the relief only applies to assets within the capital gains regime. There are other rules for assets on which capital allowances can be claimed, stock in trade or work in progress, etc. Each of these needs to be considered separately looking at the rules applying to those assets.
Gift relief
The second method is using the gift relief rules at Section 165 of the Taxation of Chargeable Gains Act 1992. Assets are gifted to the company and transferor and the company elects that the transfer is treated as being at no gain, no loss. With Gift Relief the company effectively agrees to take on the gain transferred on individual assets and, in the future, will pay tax on this gain when it disposes of the asset.
One downside of this relief is that it only applies to the transfer of assets used by the transferor in a trade, profession or vocation so it can’t be used for investment businesses in the same way as Incorporation relief.
However, when it can be used Gift Relief can be very powerful. Unlike Incorporation Relief there is no requirement to transfer the whole of the trade or all of its assets, so this relief allows an owner to cherry pick assets to transfer on the incorporation. So the business owner with a property they don’t want to transfer to the company can use Gift Relief instead of Incorporation Relief.
A further advantage is that it’s possible to manage the level of chargeable gains, as the relief applies to the extent that you elect for it to apply. So it’s possible to manipulate the gain that is taxable to an amount that suits to the transferor. This might be useful if the owner has unused capital losses brought forward.
Conclusions
Following the December 2014 changes it seems likely that Incorporation Relief will take over as the most popular mechanism for managing the tax charge on incorporation of a business.
In some cases, particularly where the person carrying on a trade, profession or vocation does not wish to transfer the whole of that trade, gift relief might be more appropriate.
It’s also worth remembering that a sale to a company might still work if the values and assets are suitable.
However, in most cases the tax benefits of the ability to sell a trade to a company have been eliminated, and so other motives will begin to take a front seat in making the decision to transfer a business to a company.
If you need any advice on transferring your business to a company please contact one of our tax team.
Scott Burkinshaw
Scott is Tax Partner at Shorts, specialising in providing strategic corporate and personal tax advice.
View my articlesTags: Business Taxes
