A golden opportunity or a minefield?
The Dentists Act of 1956 had prohibited dentists from running their practices through the medium of a limited company, with the exception of those who’d already been providing dentistry services on 21 July 1955. At the end of July 2006, however, these restrictions were removed.
Incorporation is a complex topic and involves a number of tax issues as well as commercial and political considerations. This article explains the basic points, but it is imperative that dentists intending to take advantage of this new opportunity receive full and impartial advice to reach an informed decision.
A company is a distinct legal entity, owned by shareholders and managed by one or more directors. These can be the same individuals. If a practice is being purchased from an unconnected vendor, it is the company rather than the dentist who will acquire the goodwill, equipment etc. Where the dentist already owns the practice, either alone or in partnership, the business will be transferred to the limited company or ‘incorporated’.
The incorporation process has a number of implications. One of the key consequences is that, for tax purposes, the assets are transferred to the company at market value even if no payment is actually made. Thus when a dentist incorporates his own practice, a capital gain will usually arise although payment of tax can be deferred until the company is eventually sold.
Incorporation also marks the end of the sole practice or partnership, so there may be income tax consequences, on which your accountant can advise. Practitioners also need to be aware that accounts will be on public record at Companies House.
The most publicised benefits of practising through a limited company are the tax savings. A sole practitioner who becomes the only director and shareholder of his or her new company can take income from the company in two ways, either as dividends or in the form of a salary.
Payment of a salary involves National Insurance (NI) contributions; employer’s contributions are 12.8% of the salary, and employees’ contributions are 11%. This is an expensive option and would cost considerably more in overall taxes than remaining as an unincorporated practitioner. The other option is to pay yourself in dividends, pro-rata to the number of shares held. This is an attractive alternative as there is no NI liability.
The top rate of tax for an individual is 41% including NI. Conversely, companies with taxable profits of £300,000 or less only pay 19% tax. If the profits are retained within the company, to be invested in new equipment for example, there will be no additional tax to pay. But when those profits are distributed to the dentist, a further tax liability will arise.
So, in order to maximise the tax advantages the strategy might be:
• Pay a salary of £5,035 per annum (for 2006/07) to the dentist. This covers the Personal Allowance exactly, so is tax-free. No NI contributions are payable at this level, yet it protects the dentist’s entitlement to the basic state pension.
• Additional income requirements are provided in the form of dividends drawn from the company, on which no NI is payable.
• Retain some profits within the company for investment in equipment etc or to provide working capital. Provided the £300,000 profit threshold has not been exceeded, the company profits will only bear tax at 19%.
Assuming all profits are paid out to a single dentist, tax and NI savings compared with an unincorporated practice might be:
• on profits of £50,000 – tax saving of about £4,000 pa
• on profits of £100,000 – tax saving of about £5,000 pa.
The savings will be greater where profits are retained within the company rather than being paid out, or where some of the shares are held by a spouse in a lower tax bracket.
The formalities Company formation is relatively straightforward and inexpensive, but when it comes to dental practices, taxation issues must be dealt with properly, particularly the valuation of goodwill and its tax treatment for capital gains purposes. A professional valuation would be recommended as a defence against any challenge from the Inland Revenue.
Although the restrictions on incorporation have been removed, the General Dental Council (GDC) still has an important regulatory role. The board of directors of the company must have a GDC registrant majority – dentists or dental care professionals (DCPs) – or a combination.
Registrant directors are required to uphold high professional standards within corporate bodies, just as they are in their work as a dentist or DCP, and they are personally accountable through the GDC’s fitness to practise procedures for their conduct as a director.
In early 2007, the GDC will issue a list on which all dental companies must be registered. Each company must send in its annual return to the GDC and an accompanying fee, which will be set when the list opens. The GDC will be able to impose financial penalties on a corporate body for misconduct – for example, if the company has failed to provide the information required in their annual return or if a director or staff member has been struck off the GDC’s register for misconduct.
Many stories are circulating about incorporation, some of them untrue. Here are some examples with my replies:
• ‘The incorporation process will create a tax-free loan account within the company which can be drawn on’. Depending on how incorporation is dealt with, you can usually create a loan account of around £35,000 completely free of tax. A much larger loan account to draw on tax-free may be possible if some capital gains tax is paid following the incorporation.
• ‘Corporation tax relief can be claimed on goodwill’. A tax deduction may be claimed on expenditure incurred after 1 April 2002. You cannot get around this rule by incorporating a longer established practice.
• ‘Tax savings can be increased by paying salaries and dividends to spouse or partner’. Possibly, but non-commercial arrangements can be challenged by the Inland Revenue.
• ‘Tax can be avoided with an offshore company.’ This is rarely possible.
Incorporation works for partnerships as well as for sole practitioners. However, where the taxable profits exceed £300,000, the rate of corporation tax is higher and as a result, incorporation may therefore be less attractive.
There is also no reason why associates should not practise through a limited company, and the issues are more straightforward as there is no goodwill to consider. Care should be taken, however, under the new NHS contract if the associate is paid a fixed share of income and thus becomes more like an employee. Some penal tax rules (known as IR35) could then be invoked.
Under the new rules from April 2006, an individual can obtain tax relief on pension contributions up to a
maximum of his or her earned income for the year, but not exceeding £215,000. Dividends do not qualify as earnings for this purpose. Thus dentists who wish to make more substantial provision would need to pay themselves higher salaries. This would, however, be counter-productive as this involves NI contributions.
So what happens when the business is sold? There should not be any problem provided the purchaser also buys the company. The vendor would be liable for capital gains tax on the disposal, but with full business asset taper relief of 75% provided the company has been owned for at least two years.
If the purchaser is willing to buy the practice but not the whole company, the company will be liable for tax on the gain on the goodwill, and there is no taper relief for companies. The vendor will still be liable for capital gains tax on the shares when the company is liquidated.
Bear in mind that when a person buys a dental practice he or she generally acquires the assets – goodwill, equipment etc. The liabilities remain with the vendor. However, the purchaser of a company is taking on all the assets and liabilities, including the unpaid bills, ‘visible’ liabilities, contingencies such as PAYE irregularities and other hidden problems. The process of checks or ‘due diligence’ will become more complex and expensive, as too will warranties and so on.
Tax-motivated incorporations are not popular with the Inland Revenue. The trend for all kinds of businesses to incorporate over recent years has caused a loss of tax to the government, which it has taken steps to counteract. Recently the Revenue claimed that goodwill is not a free-standing asset but attaches to the premises. This could mean that Stamp Duty Land Tax would be due. In addition, the favourable Capital Gains Tax treatment on transfer of goodwill to the company would be denied, as would the tax relief on goodwill within the company.
Incorporation may be the best route for some practices, but it may not be suitable for all. Limited Liability Partnerships may provide an alternative but the importance of taking professional advice cannot be overemphasised.
Incorporation is good for large practices or groups of practices because:
• It’s easier to attract loan finance
• The possibility of external investors
• The range of corporation incentive schemes available to staff
• The lower tax regime for profits retained in the company for investment in equipment, etc
• It’s easier to sell or pass on shares in a company.
For smaller practices, the tax savings provide an incentive to incorporate but consider:
• Additional layers of administration and costs
• Changes in tax rules and Inland Revenue attitudes that make the advantages less certain
• It’s not advisable for practitioners with poor record keeping or dentists who spend more than they earn
• Once the practice is incorporated, it can be difficult to unravel.