Under the last government, there were for a period of time considerable tax incentives towards incorporating small business and operating it through the medium of a company. These incentives were eventually reduced, but it still remains the case that most successful businesses can achieve some tax savings by operating through a company, rather than being operated as a partnership or a sole trade.
Running a company
Although there are advantages in using a company, it must be recognised that there are higher costs involved and also more administrative work. Throughout the year, there will be a variety of forms and returns to be completed and submitted, either to HMRC or to Companies House, and in most cases failure to do so on time will incur a penalty.
For a company with a 31 December year end, a typical year will run along the following lines. Assuming that it was formed at around that time of year, there will be an annual return to be submitted to Companies House during January. In May a PAYE return must be submitted to HMRC. In July a P11D form must be submitted to HMRC. On any occasion through the year when the company makes a payment of salary or remuneration, it must first submit the relevant details to HMRC under the new "real time information" system in order to receive from HMRC the figures for tax and national insurance to be deducted. By the end of September accounts drawn up to a required standard must be submitted to Companies House. At the same time the Corporation Tax liability for year concerned is due. Finally, on or before 31 December, a Corporation Tax return is return which must be filed with the accounts for the company converted into a specialist format and filed electronically.
Many people fail to appreciate that once the business has been transferred to a company, the profits do not belong to either the directors or shareholders, but they belong to the company which has a legal status of its own. The money cannot therefore just be spent by a director as his own funds but drawings from the company must be in the form of either properly declared dividends or remuneration with prior notification to HMRC as already mentioned. Using a company credit card for private expenditure and then putting a label of "dividends" on the total at the year-end is unlikely to be accepted by HMRC.
Reverting to sole trade or partnership
One of the oddities of the UK tax system has been that there are several reliefs to enable a business to be transferred to a company without any tax charge, but there has been no similar set of reliefs to enable a business to be taken out of a company and back into sole trader or partnership form without incurring tax liabilities.
To take the simplest of examples, assume that a company is operated by its sole director and shareholder and it has no fixed assets as such but simply the profitable trade carried on by the director. If the director should decide that the administration requirements of running the business through a company are too great, it will not be simply a matter of closing down the company and continuing the business personally. It is likely that the business will have valuable goodwill and closing down the company will result in the company disposing of that goodwill to the director. Normally, this would give rise to corporation tax liability within the company on the value of the goodwill less its base cost within the company. Equally, the shareholder will have disposed of his shares in the company by closing it down, and the capital gain the shares will also be realised and be liable to capital gains tax. The rate of tax may be only 10% under the provisions for entrepreneurs relief, but there are very detailed conditions for this relief.
Unfortunately, even this is not the complete picture. If the value of the goodwill and any other assets in the company such as cash reserves exceed £25,000, the simple act of continuing the business outside the company would result in the whole value of the goodwill and the cash distributed out being liable to income tax, and not capital gains tax, in the hands of the director. This is because all the assets of the company will be treated as a "distribution" or dividend paid by the company to its director. Any funds taken out of a company by its shareholders during the life of the company are income distributions, unless taken under a procedure known as ‘capital reduction’ for which there are quite detailed rules and requirements.
To prevent the funds taken out being treated as income distributions, the company would need to go into formal liquidation, with a liquidator being appointed, and the costs of this will be at least £4,000, and very often significantly more than that. All distributions made by a company in a winding are then outside the scope of the income tax charge on company distributions.
Very small companies can be wound up informally without the appointment of a liquidator, but this applies only where the total assets of the company are £25,000 or less. Informal liquidations within this threshold are not treated by HMRC as income distributions to the shareholders, and capital gains tax treatment applies.
A New Relief
Some assistance for those who wish to disincorporate is to be provided by this year's Finance Act. A new "disincorporation relief" will be introduced and this will enable fixed assets to be distributed out of the company without the company being liable to corporation tax, as was mentioned above. Therefore, to revert to the example of a company which has only goodwill as its fixed asset, if one assumes that the goodwill has a value of £100,000, but the initial cost price to the company was £20,000, the new relief will enable the goodwill to be transferred to the shareholder at its cost price of £20,000 with no tax liability arising in the company. This will apply to business transfers occurring on or after 1 April 2013. There are further conditions:
1. The business conducted by the company must be transferred as a going concern with all of its assets, apart from cash.
2. The total market value of those assets must not exceed £100,000.
3. The shareholders must have held their shares throughout the 12 months before the time of transfer.
4. All the shareholders must be individuals, or individuals as members of a partnership.
Limitations of the New Relief
It will be seen that although there is to be a relief from tax for the company, there is no corresponding relief for the capital gain which the shareholder realises on winding up the company. Nor is there any corresponding relief from the income tax charge already mentioned, if the company is not wound up when the business is transferred.
In nearly all cases therefore the new relief will not mean that a business can be disincorporated without any tax charge at all. There may be no tax charge within the company, but in most cases there will be a capital gains tax liability on the shareholders receiving the business because, to prevent the whole process being taxed as an income distribution, they must cease to have their shares by virtue of winding up the company, whether in a formal liquidation or an informal winding up. That has the result that the gain on the shares is realised. For a trading business, the rate of tax on the shareholder may be only 10%, as already mentioned, but no doubt any tax incurred will be unwelcome.
One circumstance where the new relief may be particularly valuable is where the principal director and shareholder has died and the shares have passed to a beneficiary under his will who wishes to continue the business. The beneficiary will receive the deceased's shareholding with a capital gains tax base cost equal to its current market value at the date of death, i.e. probate value. In such a case the business may be disincorporated with minimal tax on the shareholder and with the benefit of the new relief on the company.
Difficulty
One problem with the new relief is that it applies only where the value of the assets qualifying for it does not exceed £100,000. The problem with this limit is that, whilst it may be a relatively straight-forward matter to value machinery or offices etc. in a company, the value to be placed on goodwill is much more subjective and open to debate. It will not be possible to agree a value with HMRC before going ahead with disincorporation. Accordingly, one would need to be certain that the value of all the fixed assets distributed including goodwill does not exceed £100,000 before going ahead with disincorporation. If HMRC should take the view that the assets do exceed this upper limit, and their view has to be accepted after negotiation, the new relief will not apply and there will be tax liability within the company.
Trading Stock and Equipment
On disincorporation, there are provisions by which the trading stock in the company may be taken over by the disincorporated trade at the cost price to the company so that the transfer does not give rise to any profit within the company.
Equally, machinery and plant which has qualified for capital allowances within the company may be taken over at its tax written-down value; this requires a joint election by the company and the transferee.
Summary
The new disincorporation relief has been introduced somewhat tentatively for a period of five years from April 2013. It seems likely that it will have very limited appeal, but nevertheless there will be some who consider it to be sufficient incentive to step off the treadmill involved with incorporation and revert to sole tradership.
For General Information Only:
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to 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. If you would like to discuss any of the points raised within this memorandum please contact either Charles Little FCA or Anthony Brice FCCA on 01234 301000
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