From little acorns grow large oak trees and so it is that larger businesses start off small, often as a sole trader, a partnership or limited liability partnership (LLP). However there are advantages to businesses incorporating, that is, becoming a limited company, not least of which are the tax advantages plus, of course, the limited liability and protection from creditors.
No business wants to pay more tax than they have to and by incorporating a business significant income tax saving can be achieved by using a properly structured company. This is based on the fact that when you transfer your business to a limited company you are viewed legally as personally selling it to the new limited company. For tax purposes, this is the same whether you are a sole trader, a partnership or a LLP.
Part of the process involves the ‘sale’ of the business to the new limited company that’s been set up. The question many ask is ‘what is the price I am deemed to be selling at?’ The answer is simple – the market value of your business; what you could reasonably get for your business in the open market.
You may already have had offers or you could get a valuation from a business transfer agent. The valuation will include the fixed assets such as equipment and also importantly the goodwill. Your accountants can help with a goodwill valuation which in many cases will be where the value in the business is. The main thing is to have a ball park value which may be needed for tax purposes. If you set up the business from scratch there will usually be a significant capital gain as you will have paid almost nothing for the business.
Luckily you’ll not normally have to pay capital gains tax when you incorporate your business. This is because you can opt to have the gain rolled over into the value of the shares in the new company – the shares in the new company will have the same value as your business had originally, in most cases almost nothing. So if the business had an almost zero capital value when you set it up but is now worth £1m when you incorporate it, the shares you get in the new limited company are deemed to be worth almost nothing for capital gains tax purposes and not £1m. Obviously if you subsequently sell the shares in the company you will pay capital gains tax on the whole sale price and not on the sale price less £1m.
The next natural point that some consider is that they don’t want to pay tax later when they really only sold the business to themselves in the first place and got no cash in return.
And that’s a fair point and one based on the conventional approach if they generally followed advice from their accountants. Here they will pay capital gains tax when they eventually sell the shares in the company; so if they finally sell the shares for £2m they will have a capital gain of £2m. This way they have stronger cash flow as they do not pay any capital gains tax until they receive hard cash from a buyer. However, all money they take out from the company either as a salary or as a dividend is taxed in their hands as Income tax.
Another option is to not opt for the exemption at the time of the ‘sale’ to the newly formed company and instead pay the capital gains tax up front. So in the example above you pay capital gains tax on the £1m gain at 10% (Entrepreneurs Relief should apply) – £100,000.
The process is very easy to achieve and quite painless. You simply tell HMRC you are going to pay the capital gains tax. It means that in the example the shares you have in the new company now have a base cost of £1m and not zero because you have paid the capital gains tax.
Of course some might argue that paying capital gains tax when they don’t have to, and also when the company has not actually paid any cash, might seem a daft thing to do. But there is rhyme to the reason.
In the above case the company now owes you £1m which is the purchase price. It has to be in the form of a loan you have made to the company as the company has no money to pay you the price of the business it now owns. You will have to pay roughly £100,000 capital gains tax (10% of £1m with Entrepreneurs’ Relief) and the company now has to pay you the £1m which will be tax free. It is not a salary and it is not a dividend. This repayment is of a debt which the company owes you personally. Of course you will normally also take a small salary in addition to repayment of your debt.
The net result of this arrangement is that you pay no income tax and no national Insurance and your £1m debt can be paid off by the company over a few years with all the money tax free in your hands. Remember there is no tax because this is a repayment of your loan to the company when it bought your business. This is the big advantage of this scheme. You might as well get this money paid to you as fast as the company can manage as the money is tax free in your hands.
Moving on, the company will pay corporation tax on its profits. This means that roughly on the future profits of £1m you extract from the company you will pay a total of 20% corporation tax (at today’s rates) plus the 10% capital gains tax you’ve already paid, 30% tax in total. However – and this is the big plus – you avoid both income tax and national insurance on the £1m you extract from the company going forward. In the case of most profitable companies you will be comfortably ahead in terms of any tax liability and you will generally be protected from creditors.
Naturally when the £1m loan is repaid you’ll then extract profits from the company by way of a salary and dividend. The other tax advantages however end. All the partners in the business being sold can participate; they will all sell to the limited company and so will all have a debt due to them from the company. Normally their debts will all be paid down equally by the company.
And in terms of VAT, none should be due on the sale. You can opt to either keep your VAT number or the limited company can apply for a new VAT number. It may be easier to keep your VAT number though you continue to be liable for any historic issues with it.
There will be fees for the transaction but normally the tax savings make the fees a small outlay. You will need to involve your accountant and a solicitor and the fees are also tax deductible.
As with anything, there are risks and HMRC may challenge the valuation of your business. You need to have some way of showing the value is realistic. Although it is tempting to go for a high valuation remember you have to pay the capital gains tax up front when you sell to the limited company. If your business fails going forward you still have to pay the capital gains tax even though your loan is not repaid by the company. This is a real risk in structuring your incorporation this way. But get it right and you’ll be quids in.
David Anderson is a solicitor advocate, barrister (unregistered) and Chartered Tax Adviser at Sykes Anderson Perry Limited.