Should I incorporate my business?

One of the most important questions when carrying on a business is whether it should operate as a sole trader, a partnership or a company. Once the decision has been taken, it is necessary to review the position regularly in the light of changes in legislation and the regulatory environment.

COMMERCIAL IMPLICATIONS

It may be tempting to make the decision purely in relation to the taxation implications. It is true that these may be very important (and they are discussed later) but frequently the commercial considerations will be more important.

For some businesses, incorporation may not be possible as there are restrictions on the use of companies for carrying on certain types of professional work, such as barristers and the NHS practices of Doctors and Dentists.

One reason for favouring incorporation is that it enables you to operate with the benefit of limited liability. This can be especially important if the business is ‘high-risk’ or particularly prone to litigation claims. Examples are to be found in the building trade and certain consultancy businesses. A major claim from a customer/client could potentially bankrupt your business and you as proprietor.

Of course if the business is carried on through the medium of a company the company could be forced into liquidation. However, unless you have given personal guarantees, or security, your own liability would normally be limited to the amount you have invested in the company.

Another important benefit from operating through a company is that it enables a share incentive scheme to be set up. A properly structured share scheme offers a method of incentivising key staff in a way which simply would not be possible in an unincorporated business.

Confidentiality is another important matter. A sole trader or a partnership is not required to publish a profit and loss account or balance sheet. However, limited companies over a certain size must file detailed financial information with the Registrar of Companies each year, and this information is available to the public, including of course your competitors.

In addition, there are a number of other ways of carrying on a business, apart from as a sole trader, a partnership or a limited company. For instance, an “unlimited company” may be used. Although an unlimited company still has to be registered at Companies House, it is not necessary to file the same level of detailed financial information as applies with many limited companies.

A further option has recently become available with the introduction of the limited liability partnership. This is a ‘cross’ between a partnership and a limited company, and offers the advantages of limited liability combined with a low level of public disclosure of financial information. Each partner in a limited liability partnership is liable to Income Tax on his (or her) share of the profits.

We will be happy to steer you through the various structures and advise which is the best approach in your particular circumstances.

TAX IMPLICATIONS

Having considered the commercial background, it is also necessary to consider the tax implications of incorporation.

The top rate of personal Income Tax is currently 40%. In addition to this, a self-employed person (including a partner) must pay 8% National Insurance Contributions on profits between £4,895 and £32,760, plus 1% on all profits above £32,760.

As far as companies are concerned, the rates of Corporation Tax were until recently:-

Taxable profits	Up to £10,000	Nil
Taxable profits	£10,001 - £50,000	23.75% marginal rate
Taxable profits	£50,001 - £300,000	19%
Taxable profits	£300,001 - £1,500,000	32.75% marginal rate
Taxable profits	Above £1,500,000	30%

The nil rate of Corporation Tax on the first £10,000 of profits was introduced with effect from 1 April 2002, and was a strong incentive to carry on business through a company. Thus, a business with a taxable profit (before the proprietor’s salary) of £30,000 might pay the owner a salary of £20,000, thus reducing the taxable profit to £10,000. No Corporation Tax would be payable at this profit level. The net-of-tax profit of £10,000 might be paid to the proprietor as a dividend. He (or she) would probably not have any higher-rate tax liability and would not pay any National Insurance contributions on the dividend (nor would the company!).

This was a very attractive proposition, and could be even more attractive if both spouses were active in the business.

The Chancellor was frequently warned in 2002 that the nil rate of Corporation Tax would lead many more entrepreneurs to operate through companies. He appeared to be relaxed about this at the time, but then decided that this form of tax-saving was unacceptable!

As from 1 April 2004, a company could no longer benefit from the nil rate of Corporation Tax to the extent that it paid dividends to individuals – or trustees.

Thus, for the year ending 31 March 2005, the company in the above example would have to pay Corporation Tax of £1,900, i.e. 19% of £10,000. It would therefore only have £8,100 to distribute by way of dividend, unless it had accumulated reserves to draw on.

This introduced a whole new raft of extremely complex legislation which has now been entirely swept away by the Chancellor’s decision to abolish it entirely along with the nil rate of corporation tax. So we are back where we started!.

We have mentioned the extraction of profits from a company by way of salary or dividends. A third way involves the liquidation of the company, and the withdrawal of surplus funds in the course of liquidation. Capital Gains Tax will normally be payable in these circumstances, but there are some generous CGT reliefs (annual exemption and taper relief) which may substantially reduce or eliminate the tax liability.

It should be noted that there is a potential “double Capital Gains Tax effect” when a company owns a property or certain other assets. If the company sells the asset it has to pay Corporation Tax on the gain, subject to the deduction of an indexation allowance for inflation.

However, further tax is payable in respect of the same gain when the shareholder sells his (or her) shares in the company or when he (or she) receives a lump sum in respect of the shareholding on the winding up of the company. Although this liability may be alleviated (as mentioned above), the “double Capital Gains Tax effect” may be an unpleasant surprise for the unwary. In certain circumstances it may be beneficial to retain key assets outside a company (please see the Appendix for an example which illustrates this point).

NO SIMPLE ANSWERS!

In very broad terms, the proprietor of an unincorporated business liable to tax at 40% needs to earn one-third more pre-tax profit to fund capital requirements (including loan repayments) out of income than a company liable at the 19% rate.

However, there are no ‘rule-of-thumb’ solutions. Careful analysis will be needed in each case to arrive at the right decision.

It is also necessary to look at the long-term tax position in connection with the ownership of assets such as freehold property, long leases and goodwill. As mentioned earlier, the total tax ultimately payable on disposal of assets of this kind can be considerably greater where a company is the owner. Problems can also arise if you are considering the transfer of a business property into a new company. There are some potential tax pitfalls here, and the transfer will need to be carefully structured in order to optimise the tax position.

If you do decide to incorporate and your new company is a “personal service company”, it may be caught by the legislation introduced in April 2000 which affects this kind of company. In some cases, incorporation could be a futile exercise, since you may subsequently be held by the Revenue to be “employed” by your clients! The special rules attacking personal service companies now cover companies employing domestic workers.

If you transferred your business into a company in recent years, the position may need to be reviewed, and we shall be happy to do this, if you wish. In some cases, the Revenue are attacking the tax savings, using the anti-avoidance legislation relating to settlements. We can advise whether such an attack is likely in your own particular circumstances and – if so – whether it can be resisted.

We can also advise whether it would be sensible to disincorporate, but it should be borne in mind that it may be costly in tax terms to do this; there are special reliefs on incorporation, but there are currently no reliefs on disincorporation.

If you are considering liquidating your company to return to self employed status, remember that goodwill is a capital asset which could be liable to Corporation Tax on capital gains on a winding up, even though it does not commonly feature as an asset in the Balance Sheet.

WHAT ABOUT GOODWILL?

As already indicated, consideration should be given to the principal shareholder owning major assets and leasing them to the trading company if a corporate trading medium is desired.

Let us suppose that Fred has decided to set up in business and to operate via a limited company (“Newco”). It may be possible for him to license his business idea to Newco under a contract while retaining ownership of the goodwill. This is not common, but it is understood that it can be achieved in appropriate circumstances.

Legal advice would be essential prior to entering into an arrangement of this kind, but, if Fred in due course wishes to sell out, he will be able to sell both the shares and the rights to the goodwill to a purchaser. It should be noted that the goodwill may be fully chargeable to Inheritance Tax in the event of Fred’s death, and it may be appropriate to take out life assurance cover in this respect.

Sometimes, a business will buy a franchise from a franchisor. The capital expenditure will require careful analysis to determine the correct tax and accounting treatment. If goodwill is a substantial component of the purchase price, it should be borne in mind that tax relief may now be available if the goodwill is purchased and held in a company. This relief is available only to companies.

SEEK ADVICE

It can be seen from the above that there are many different matters to look at when deciding how best to structure your business. (We have not considered VAT, Stamp Duty or Inheritance Tax, but these can be very significant).

Achieving a tax-efficient structure now could substantially reduce the amount ultimately payable to the Exchequer.

In addition, there are other issues to be considered in order to reach an informed decision. For example, the purchase of a new asset may well involve borrowings. We can assist you in your negotiations with lenders so that tax-efficient structures are not needlessly discounted in order to meet a lender’s requirements.

HOW WE HELP YOU

The proprietors of the majority of successful unincorporated businesses are well advised to review their position from time to time. Thanks to recent changes in tax legislation, it may be that those who decided not to incorporate four or five years ago should look again at their options. As already indicated, there is no optimum level of profitability above which incorporation becomes the only sensible course.

What is required is an appraisal of your situation. We can discuss your business plans and anticipated levels of drawings for, say, the next five years or so, and we can talk through some of the issues with you. Issues such as the impact of the amounts of NIC payable out of the profits being generated by the company's business, the payment of dividends to working shareholders and the level of income tax payable for the year in which the trade 'ceases' for income tax purposes.

We can prepare a cash flow summary showing the revised amounts of tax and NIC payable and the due dates thereof as a result of incorporation. Should it be decided that incorporation of your existing business is desirable we can advise you on the mechanics. Post incorporation pension planning may also need to be discussed.

You will already have gathered that incorporation is not a decision to be taken lightly. We are experienced in helping clients restructure their businesses and we shall be pleased to assist you. Do not hesitate to contact us to discuss your particular situation.

APPENDIX

SCENARIO A

Stanley liquidates his trading company in the year 2010. Throughout the company’s existence Stanley personally owned the trading premises which he let to the company at a market rent.

Stanley receives proceeds from the liquidation of the company which give rise to a capital gain on the realisation of the company’s shares of £400,000. Stanley is liable to tax at 40%. Therefore, on this gain his tax liability is calculated as follows:

	£
Gain as assumed above	400,000
Less taper relief @ 75%	300,000
	100,000
Therefore, tax on realisation of shares at 40%	40,000

Stanley also sells the trading premises, making a £1 million gain. His trading company occupied the premises throughout his ten year ownership. Stanley can claim that the capital gain arising on the business premises attracts the business asset rate of taper relief. Accordingly, Stanley’s tax liability in respect of the trading premises as calculated as follows:

	£
Gain as assumed above	1,000,000
Less taper relief @ 75%	750,000
	250,000
Therefore, tax on property sale at 40%	100,000 (1)
Stanley’s total capital gains tax bill is therefore:	140,000

SCENARIO B

The facts are as in Scenario A except that it is now assumed that Stanley decided originally to let the company purchase the business premises (which cost £600,000 in both scenarios). He still financed the purchase by lending an amount equal to the purchase price to the company, which remained outstanding until being repaid after the sale of the premises by the company in 2010. The impact of the growth in value of the trading premises falling inside the company, i.e. rather than immediately arising in Stanley's hands, can be demonstrated as follows:

Annual exemption has been ignored in the above calculations.

	£
Capital gain on premises realised by company	1,000,000
Less indexation allowance, say, 35% of cost	210,000
	790,000
Tax payable by company:
Say tax rate in 2010 - 30%	237,000 (2)

	£
Therefore, additional funds available to shareholders on liquidation, attributable to the growth in value of premises locked inside company, £1,000,000 less £237,000 i.e.	763,000
Therefore, additional capital gain arising to Stanley on realisation of shares:
Additional proceeds	763,000
Less 75% taper relief	572,250
Taxable	190,750
Tax payable by Stanley @ say 40%	76,300 (3)

COMPARISON

	£
The tax payable in Scenario A on the gain on the property was only £100,000 (see item 1) whereas in Scenario B:
The company pays	237,000 (2) above
Stanley pays	76,300 (3) above
	313,300

The effective tax rate on the property gain is only 10% if Stanley owns the property throughout, whereas it is increased to 31.3% as a result of company ownership.

N.B. As indicated, other issues, such as inheritance tax and VAT must be considered.

Click here to return to Ask The Experts

FOR GENERAL INFORMATION ONLY

Please note that this answer is not intended to give specific technical advice and it should not be construed as doing so. It is designed to merely alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.

© 2006 - Gordon Leighton.

Gordon Leighton is registered to carry on audit work by the Institute of Chartered Accountants in England and Wales