Income Tax Savings on Incorporating a partnership or LLP
By David Anderson Solicitor Advocate, Chartered Tax Adviser and barrister (unregistered) at Sykes Anderson Perry Limited Solicitors and Chartered Tax Advisers in London, England
This information has been prepared by Sykes Anderson Perry Limited as a general guide only and does not constitute advice on any specific matter. We strongly recommend that you seek professional advice before taking action. No liability can be accepted by us for any action taken or not taken as a result of any information or advice given or omitted.
Q. I run my business as a sole trader or partnership or limited liability partnership. What tax advantages do I get by changing it to a limited company?
A. A significant income tax saving can be achieved by a properly structured incorporation. This is based on the fact that when you transfer your business to a limited company you are personally selling it to the limited company. This is the same for tax purposes whether you are a sole trader, a partnership or a LLP.
Q. So I am treated as selling my business to the new limited company I have set up. What is the price I am deemed to be selling at?
A. The market value of your business. What you could reasonably get for the business in the open market. You may already have had offers or you could get a valuation. It 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. If you set up the business from scratch there will usually be a significant capital gain.
Q. So do you usually pay Capital Gains Tax when you incorporate your business?
A. Normally you don’t. You can opt to have the gain rolled over into the value of the shares in the new company. In other words the shares have the same value as your business had originally. So if the business had an almost zero capital value when you set it up but is 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.
Q. This sounds good. I don’t want to pay tax when I am really selling my business to myself and getting no cash.
A. This is the conventional approach. You will pay capital gains tax when you sell the shares in the company. So if you finally sell the shares for £2M you will have a capital gain of £2M.
Q. So what’s your tax angle?
A. You don’t opt for the exemption and instead pay the Capital Gains Tax. So in the above example you pay capital gains tax on the £1M gain at 10% (entrepreneurs relief should apply).
Q. Sounds crazy. Why should I pay Capital Gains Tax when I don’t have to and when the company has not actually paid me any cash?
A. In the above case the company now owes you £1M which is the purchase price. You have paid £100,000 Capital Gains Tax (10% of £1M). The company now has to pay you personally the £1M which will be tax free. It is not a salary and it is not a dividend. It is repayment of a debt the company owes you.
Q. So I pay no income tax on the £1M repayment?
A. Yes and also no national Insurance. Your £1M debt can be paid off by the company over a few years with all the money tax free in your hands.
Q. Does the company pay corporation tax?
A. Yes. It will pay corporation tax at say 20%. This means roughly on future profits of £1M you extract from the company you will pay 20% corporation tax + 10% Capital gains tax = 30% tax in total. You avoid 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 tax wise.
Q. What happens when the £1M loan is repaid?
A. You extract profits from the company by salary and dividend. The tax advantages end.
Q. What are the risks?
A. 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.
Q. What are the fees for doing this?
A. Normally the tax savings make the fees a small outlay.
2nd May 2014
David Anderson Solicitor Advocate, Barrister (Unregistered) and Chartered Tax Adviser
Sykes Anderson LLP
9 Devonshire Square
London EC2M 4YF
Telephone 020 3178 3770