In any economic downturn business owners will look for different ways to preserve cash and minimise their risk. The current climate is no different.
The Perils of the unincorporated Business
Individuals who operate an unincorporated business (i.e. sole trader or general partnership) have a double risk if the business does not generate enough reserves to meet its ongoing liabilities. A creditor could pursue the business owner personally to meet these liabilities. One way to mitigate this risk is for the business owner to incorporate their business.
The Advantages of trading through a Company
The main advantage often associated with a company is the limited liability status (LLS) it offers to its shareholders. With LLS, shareholders are only at risk for the amount they invest in the company including any amounts owing on issued but unpaid shares. This benefit is sometimes lost when shareholders (who are also directors) are asked to give personal guarantees to third parties.
Tax Issues relating to the incorporation of an existing unincorporated Business
Incorporation is the process of forming a new company.
The incorporation of a business is a disposal for Capital Gains Tax (CGT) purposes, and it is this tax charge on which most tax planning is focused. Furthermore, the increase in property prices over the last few years has also brought Stamp Duty Land Tax (SDLT) to the forefront and this is another area where a significant tax charge can arise without careful planning.
What follows is a brief overview of the main tax issues that need to be considered on the incorporation of a business.
CGT Incorporation Relief
As the company and the former owner(s) of the unincorporated business are connected for CGT purposes the chargeable assets transferred must be valued at market value. This tax charge can be deferred in whole or in part under a relief known as “incorporation relief”. Providing all the assets of the business (excluding cash if desired) are transferred to the company the rules generally provide that the CGT charge will be deferred if the business owner receives shares in the company in exchange. The deferred CGT charge will become payable when the shares are sold.
There is no need to submit a claim for incorporation relief. The relief is mandatory if the relevant conditions are satisfied.
Where the consideration for the business is satisfied partly by shares and partly by cash, or amounts are left outstanding on the shareholder(s) loan account an immediate charge to CGT will arise on the cash element.
The disadvantage of relying on incorporation relief is that all assets (other than cash) of the business must be transferred to the company. In cases where substantial property assets have been transferred, this is likely to result in an SDLT liability.
CGT Holdover Relief
If incorporation relief is not considered appropriate it is still possible to defer any CGT liability on the incorporation by claiming another relief known as holdover relief. This relief is given on each particular asset that is transferred to the company. As such there is no requirement to transfer all assets of the business to the company to enjoy this relief.
In situations where holdover relief is claimed, the capital gain is deducted from the market value of the asset which the company receives from the former business owner(s). This means that the deferred CGT charge will crystallise when the company disposes of that asset.
The business owner(s) and the company sign a joint election to holdover the chargeable gain arising on the transfer and this claim must be submitted to HM Revenue & Customs (HMRC) within certain time limits. In practice, claims are usually submitted with the Tax Return dealing with the relevant asset disposal to the company. This avoids the business owner(s) from having to pay any CGT liability and then recovering it from HMRC once the holdover claim has been made.
Value Added Tax
The general rule is that the disposal of goods forming part of the assets of the business is a supply made in the course or furtherance of the business. As such VAT will be chargeable on the sale of fixtures, fittings, goodwill, plant and machinery, and stock. However, where the trade and assets of a business are transferred to another person as a going concern (i.e. on incorporation) no liability to VAT arises provided various conditions are met. Essentially, providing the company use those assets for the same kind of business and is a taxable person for VAT purposes, or becomes one at the time of the transfer, if the previous business owner was VAT registered then no charge to VAT will arise on the incorporation of the business.
Generally, a liability to SDLT arises on the transfer of UK land and property if the value of the assets exceeds a certain value and consideration passes between the two parties.
Special rules apply in situations where land and property is transferred to a “connected company”. In this situation the consideration is deemed to be (not less than) current market value. This rule therefore applies regardless of whether the property is transferred for full consideration in the form of shares or by way of gift or sale at an undervalue. Different rules apply to partnerships that are incorporated and specialist advice is required on this area.
It should also be noted that holdover relief does not require all of the assets to be transferred to the company and so a charge to SDLT can be avoided by the former business owner retaining the property in their personal ownership and perhaps letting it to the company.
Not only will the incorporation of your business help protect your personal wealth, but it will also offer you other opportunities in the future to mitigate your personal tax bill. However, the incorporation of a business is fraught with pitfalls and specialist advice should always be taken before proceeding. This includes the preparation of the appropriate legal documentation (i.e. a business transfer agreement) as well as the appropriate tax elections and claims.
These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.