Chris Thorpe outlines some potential dangers inherent in incorporating a business.
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Many small businesses will start out as sole traders – the owner and the business are one and the same. Personal and business assets are kept apart only by a set of accounts and a balance sheet; and for tax purposes, the sole trader is taxed on the profit, not withdrawals. In effect, they are the business.
Risks inherent within that business, or the high burdens of income tax (or both), may lead to ‘incorporation’ (i.e., transferring the business into a limited company); but is incorporation worth it?
Tax consequences
When business assets are transferred into a limited company, there is usually a capital gains tax (CGT) charge. However, if all assets (except cash) are going into the company in return for newly issued shares, an automatic type of rollover relief is available in the form of incorporation relief (under TCGA 1992, s 162); the gains from the sale of the assets reduce the base cost of the shares (NB an alternative form of CGT relief is potentially available on the transfer of business assets to the company, which is not considered here).
As well as the automatic aspect (if the relevant conditions are satisfied), an interesting point about this relief is that it applies to the incorporation of a ‘business’; CGT reliefs are usually only available for ‘trades’. This gives opportunities for investment-type assets run on a commercial basis to benefit from this relief (e.g., rental properties, such as an apartment block in Ramsay v HMRC [2013] UKUT 0226).
If land or property is going into a company, another tax to consider is stamp duty land tax (SDLT) in England and Northern Ireland (or the equivalent taxes in Scotland and Wales). The SDLT legislation (FA 2003, s 53) deems market value consideration to be paid by a connected company ‘purchaser’. This is particularly onerous, not only because of the 14-day payment criterion, but there is no actual cash consideration from the company from which to pay the tax (i.e., it is a ‘dry’ tax charge).
Tax tail wagging the commercial dog?
Despite those potential tax costs of incorporation itself, ideally the ongoing tax savings will offset them; the company’s profits are subject to maximum 25% corporation tax, as opposed to 45% income tax (plus National Insurance contributions (NICs)).
Tax considerations are clearly important, but the danger is of the business owner letting the ‘tax tail wag the commercial dog’; a company is another person (a ‘body corporate’) and becoming a shareholder and director (which carries significant statutory and common law duties) is a big deal; maintaining a company takes time and costs (including submission of accounts and returns to Companies House) and it is necessary to ensure that the provisions of the Companies Act are met. Taking on all this might not make the gain worth the candle.
Another person
As a sole trader, the profits already belong to them and have already been taxed, so they can generally help themself to the business bank account funds unhindered.
However, once the business is incorporated, those profits belong to the company, so the owner cannot just help themself to those profits as before; instead, the profits extracted must be in the form of salary, bonus, dividends, pension contributions, etc. Whilst the owner is the same person doing the same job for the same customers as before, the business and profits are no longer theirs, despite owning and directing that company to which they now belong.
Double taxation
Another significant danger of incorporation is that one might end up paying even more tax than as a sole trader; the same business profits which are potentially subject to corporation tax at 25% will also be subject to income tax (and possibly NICs) when extracted as salary or dividend.
The tax benefits of incorporation are based on the optimum level of profit extraction, such that the combined burden of corporation and personal taxes is less than that of the sole trader. However, if the business owner wants most or all profits in their hands, double taxation will make the imposition of a company less attractive.
Practical tip
If a business owner wishes to incorporate, the initial costs of incorporation and extent of profit extraction need to be considered to determine whether the exercise is worthwhile, but wider non-tax factors of operating a company must also be considered.
