The incorporation decision should also encompass a review of the long-term objectives for the business and its owners, as well as an assessment of the one-off costs of incorporation.
Not just tax
Non-tax issues are as important as the tax savings for many businesses, as those non-tax issues will involve costs and obligations for the business owner. Such matters to consider may include:
1. The expectations of the customer base. In certain sectors all suppliers are expected to trade as companies.
2. The number of people involved in the business. Where two or more people are involved, a partnership or company will be needed. In which case the administrative costs of running a partnership should be compared to those incurred by a company.
3. The flexibility required. The share structure of a company permits fractions of the business to be transferred easily and to be held by investors who may not be actively involved in the day-to-day management.
4. The need to protect personal assets of the business owners. A limited company or LLP will provide some protection from creditors for the personal assets of the business owners.
5. Administrative costs and hassle.
A company has more filing obligations and will require more administration, incurring higher costs than an unincorporated business
The tax relief available to companies
• Enhanced relief for research and development (R&D tax relief).
• Reduced tax on income from exploiting patents (Patent Box).
• Enhanced relief for the creation of films, TV programmes, video games or theatre productions.
• Tax relief for investors using the Enterprise Investment Scheme (EIS), or Seed Enterprise Investment Scheme (SEIS) or Social Investment Tax Relief (SITR). It is important to weigh up whether the value of a tax relief that is only accessible through a company outweighs the increased costs of operating through a company.
Companies are permitted to makes the following deductions, which are or will be restricted for an unincorporated business:
• Interest and finance costs for letting residential property (restricted from April 2017).
• Depreciation of intangible assets. Companies are not permitted to use the cash basis of accounting or fixed rate deductions (also called simplified expenses), which may make a difference to the level of taxable profit. Administrative costs The additional costs and hassle involving in running a company should not be underestimated. For example, when operating as a company the business owner will need to:
• Operate separate bank accounts for the company and maintain records of payments made to the business owners.
• Draw-up and submit annual accounts that comply with company law to Companies House.
• Submit an annual return to Companies House, including a filing fee.
• Tag figures in the accounts and tax return to submit both on-line to HMRC. A company will normally have to operate a PAYE scheme to report salary and benefits paid to its directors and any other workers. This will require monthly RTI reports, unless the directors are paid only annually. An unincorporated business is not required to operate a PAYE scheme if it has no workers other than the business owners.
Where the business is making losses it makes little sense to incorporate until those losses have been used and the business is in profit. A loss-making unincorporated business has more flexibility to relieve losses than a company. The losses can be relieved against the other income of the business owner, subject to a cap of the greater of: £50,000 or 25% of the owner’s total income. In the first four years of the business any losses can be carried back up to three years to set against the other income of the business owner, subject to the same cap. There are restrictions on the use of losses by persons who are not actively involved in the business. Where the company makes trading or capital losses, those losses can only be used against trading profits or capital gains made by the same company, or in certain circumstances by another company within the same corporate group.
A company pays tax at 20% on its profits; a rate which is set to drop to 19% from April 2017 and to 18% from April 2020. This tax rate compares favourably with the tax due on profits made by an unincorporated business (20%, 40% or 45%) plus National Insurance contributions (NIC) at 9% or 2%. However, those tax rates can’t be directly compared, as the company doesn't have a tax-free band of income in the form of the personal allowance. Also the business owner can only enjoy profits made within the company if the funds are extracted from the company. This will generally trigger another tax and NIC charge. The quantum of tax and NIC payable will depend on how profits are extracted, whether that be as dividends, salary, benefits, pension contributions, interest, rent or more commonly a mix of these methods.
The taxation of dividends will change from 6 April 2016. The 10% tax credit will no longer apply and the dividends received in excess of £5,000 per year will be taxed at 7.5%, 32.5% or 38.1% depending on the tax band the dividend falls into. This additional tax on dividends will make incorporation less attractive, as more tax will be paid on profits extracted from the company as dividends, particularly at the higher profit levels.
Any salary payment above £8,060 will trigger an NIC charge of 12% payable by the employee and 13.8% payable by the employer (in both 2015/16 and 2016/17). The cost of the employer’s and employee’s NIC must be taken into account. However, the existence of the employment allowance, available to offset the employer’s NIC liability, must be included. The employment allowance is worth £2,000 in 2015/16 and £3,000 in 2016/17… but it won’t be available to companies with a single employee/director from 6 April 2016. A sole trader or partner is currently liable to pay Class 2 and Class 4 NIC on profits in excess of the minimum thresholds for those classes. However, Class 2 and Class 4 NIC are to be merged in the future into one charge (possibly from 2017/18) and at that time the rates of the combined NIC may well increase from the current levels of 9% and 2% for Class 4 NIC.
There are one-off costs associated with incorporating a business including:
• Setting up a new company.
• New bank accounts for the company.
• Moving loans or other financing into the name of the company.
• New letter heads, business cards, website and marketing materials.
• Capital gains tax payable by the old business owners.
• Stamp duties and land taxes on transferring property.
When a business is incorporated, the business owners will take shares in the company that give them a controlling interest. As a controller of the company, or joint controller, the former owner will be ‘connected’ to the company. Transfers of assets between connected parties are taxed as if the transfer was made at market value. Hence, where the business assets have appreciated in the individual’s hands, a capital gain may arise on the transfer of those assets to the company. Not all the business assets transferred will create a taxable gain. For example, the transfer of debtors is not regarded as a taxable asset and the value of stock and vehicles rarely appreciate over time. It is the value of land, buildings, intellectual property and goodwill associated with the business that may generate taxable gains.
There are several tax relief which can be used to shelter part or all of the taxable gains that arise on incorporation:
For incorporations before 3 December 2014 entrepreneurs’ relief could be claimed in respect of all the gains arising, if the unincorporated business had been trading for at least a year. This relief reduces the CGT payable to 10% of the net gain, after deduction of any available annual exemption. Where assets are transferred from a connected party to a close company on and/or after 3 December 2014, entrepreneurs’ relief can’t be claimed on the gains arising from goodwill or other customer-related intangible assets. It can be claimed on the gains arising on the transfer of other assets. But gains associated with the transfer of goodwill will be taxed at the full rate of CGT, unless they qualify for another CGT relief.
This relief will apply without a claim if all the conditions are met:
• The transfer of the business is made as a going concern.
• All the assets (with possible exclusion of cash) are transferred to the company.
• The former owners receive shares in the company as part or all of their consideration. The gains arising from the transfer of the assets are rolled into the value of the shares acquired. The relief may be disclaimed by election.
This relief can be claimed on an asset by asset basis, so it is not necessary to transfer all of the business assets to the company. Certain assets such as buildings, debtors or creditors can be left in the hands of the old business owner. The gain in excess of any cash consideration given for the asset is held over, to be subject to tax when the company eventually disposes of the asset. Hold-over relief must be claimed.
The transfer of assets and trade of a business will have other one-off tax implications which are here summarised: SDLT or LBTT Where land or buildings are transferred as part of the incorporation Stamp Duty Land Tax (SDLT), or Land and Buildings Transaction Tax (LBTT) in Scotland, may be due.
The timing of the incorporation can mean the loss of capital allowances in the old business. No capital allowances, including the annual investment allowance (AIA), can be claimed for the final period of trading of the old business. Where a business incorporates in the same period in which it acquires an asset, it can’t deduct the cost of that asset under the AIA. Only balancing allowances or charges can be deducted in respect of assets already held at the start of the period in which incorporation occurs. Assets which have been subject to a 100% claim under the AIA will be held in a capital allowance pool at a tax written down value of zero. When those assets are transferred on incorporation, this may create a balancing charge for the old business. To avoid such charges, the parties to the transfer can jointly elect for the assets to be transferred at their tax written down values. If this election is not made the assets are transferred for capital allowance purposes at the value agreed between the parties, which may not be market value. However, first year allowances, including the AIA, are not available on any of the assets transferred as they are acquired from a connected party.
When a business sells its assets that transaction will be subject to VAT, if the business is VAT registered. If the business has not yet registered for VAT, the transaction will count towards the VAT registration threshold. Where the assets transferred to the company constitute the entire business (or a part capable of separate operation), the transfer will fall outside the scope of VAT if: • the business (or part) is transferred as a going concern; and • the purchaser uses the assets in the same type of business; and • the purchaser registers for VAT is not already registered. The old business must notify HMRC that the transfer of assets and trade to the company is a transfer of a going concern (see VAT notice 700/9), and not charge VAT on the assets transferred. VAT advice should be taken to ensure that all the conditions for a transfer of going concern are met.
It is not easy to reverse an incorporation of a business and move the assets back into the hands of the shareholders. To achieve this goal, the company must be liquidated or informally dissolved and then struck-off.