• As discussed in these notes, a number of factors have combined in recent years to make operating a business through a limited company an increasingly attractive proposition for profitable sole trades and partnerships. These notes look at when trading through a company is a good idea and how to obtain best tax advantage from the incorporation process and during subsequent trading.
Government encouragement to incorporate
• Apart from measures such as Gordon Brown’s ill-fated zero rate of corporation tax, a number of recently introduced tax reliefs have been targeted solely at companies, including:
o Research and development tax reliefs
o Environmental tax credits
o Contaminated land relief
• The appearance that successive governments have been under the impression that all businesses operate through companies has been strengthened by the current government’s proposed programme of reduction to corporation tax rates, which will make the advantages of incorporation even more clear-cut for many businesses.
Legality of incorporation in particular professions
• Another factor leading to an increase in the popularity of incorporation has been the relaxation of restrictions on members operating as companies by various professional bodies, such as those regulating:
o The legal profession
• On the other hand, the traditional attraction of the company, limited liability for its debts on the part of its owners, has arguably become less important, both because of increasing insistence by lenders on personal guarantees by the owners and because of the advent of the Limited Liability Partnership (“LLP”), allowing a business to enjoy limited liability without incorporating.
Control over income levels
• One of the key aspects of an unincorporated business is that the owners are taxed on profits arising, not profits drawn. With a top income tax rate of 50% this can be a real problem if profits are retained in the business. Using a company to operate the trade means that the taxpayer can control the level of personal income drawn from the business, and also the form in which it is drawn. This makes for significant tax planning opportunities.
Avoiding high levels of tax on undrawn profits
• Thus for incorporation to work well as a planning strategy, it is usually necessary for the business owners to be able to leave significant undrawn profits in the business, suffering corporation tax rates at an overall maximum of 25% (from 1 April 2012) as opposed to income tax and national insurance at a maximum of 52%.
Tax-efficient enjoyment of undrawn profits
• The optimum strategy for undrawn profits is to retain them until the business is sold or the owner retires, at which point those profits can usually be drawn at an effective tax rate of 10% on sale or winding up because of capital gains tax entrepreneurs’ relief.
• Do not be tempted to artificially wind up the business and then recommence shortly afterwards; in such cases HMRC will reclassify the apparent capital gain as a dividend, suffering much higher tax rates.
Optimum remuneration strategy
• This will depend upon particular circumstances, but where the company pays tax at small companies’ rate (profits below £300,000) it is usually best to take a salary equal to the personal allowance or national insurance threshold topped up with dividends. In this way around £40,000 can be drawn from the company with no income tax or national insurance consequences.
• As an officer of the company, a director is not entitled to minimum wage. Thus avoid having a service contract (and thus being an employee), as otherwise the tax efficiency of the above structure will be compromised by minimum wage legislation.
• The structure is particularly efficient, as at these levels of pay a taxpayer is deemed to have made NI contributions for benefits purposes.
• It is usually advisable for tax and asset security reasons to keep properties outside the trading company.
• This gives rise to an opportunity to draw money from the company in the form of a market rent for the property, avoiding national insurance and representing a tax deductible cost for the company.
Separate ownership of other key assets
• The same principles that apply to property also apply to other key business assets such as intellectual property and goodwill.
• It is no longer the case that a company has to own the intellectual property in a project to obtain research and development tax reliefs, so many more businesses can now hold intellectual property separately.
Intellectual property and goodwill
• It is often possible to benefit tax-efficiently from such assets on incorporation without transferring them to the company by granting a long-term licence to exploit the assets for a capital sum. This gives rise to a capital gain which is likely to be taxed at 10% due to entrepreneurs’ relief, and can also be partly or fully absorbed by the capital gains tax annual exemption.
Transfer of other assets to the company
• Those assets which are transferred to the company are unlikely to give rise to tax liabilities on the transfer, as the tax regime provides for a couple of methods of tax-efficient incorporation of a business, either by gifting assets or exchanging them for shares in the company.
• Whilst it may appear that limited liability makes these ideal businesses to incorporate, for tax purposes this is very much not the case, as the provisions for relief of individual trading losses are much more generous and flexible than those for company trading losses.
Separate legal entity
• It is vital to remember that a company’s money is not the owner’s, and that money drawn from the company must be properly accounted for, either as remuneration or dividend. Overdrawn directors’ loan accounts have negative tax consequences, and dividends must be covered by distributable profits.
• Companies are obliged to file accounts and details of directors, shareholdings etc at Companies House, although the accounts for small companies are very much abridged.
• They are also obliged to prepare accounts in a specific format, whereas sole trades and partnerships are not technically required to prepare accounts at all (which is not to say that it is not good practice!).
• Another problem with companies is the difficulty of reverting to sole trade or partnership status; there is no tax regime to permit tax-efficient disincorporation.
• Thus beware of ‘premature incorporation’; be sure you need and want a company in the long term before going down this road.
Summary and Conclusion
• Many businesses would benefit from lower overall tax bills as a result of incorporation.
• However, all of the consequences need to be considered and evaluated before entering into a commitment to transferring the trade to a company.
• If you are considering transferring your business to a limited company, contact Mark Simpson to discuss how to take best tax advantage of this step:
• Telephone 0161 886 8062
• E-mail email@example.com