In recent years, we have observed a significant increase in enquiries in relation to the incorporation of existing unincorporated businesses, whether from self-employed individuals or partnerships.
A large proportion of these enquiries have been in relation to the incorporation of large property portfolios, however we have also seen appetite from trading businesses to move their operations to a corporate model. Many professional businesses operate from partnership models (typically Limited Liability Partnerships), with common examples being law firms and accountancy practices.
Cash extraction – unincorporated vs. incorporated business
Whilst not the sole reason, tax efficiency is certainly one of the key reasons owners of an unincorporated business might wish to incorporate. Companies pay corporation tax on profits, currently at 19%, whereas sole traders and partners pay income tax on their profit, or profit share in the case of partners, at up to 45%. Even if proposed increase in the corporation tax rate to 25% in April 2023 goes through, there is still potentially a significant benefit from an income tax perspective in running the company model.
Whether or not an incorporation is worthwhile from a tax perspective can depend on the extent to which profits are drawn from the business. Partners and self-employed individuals are subject to income tax on their entire profit share, regardless of whether they draw all of the profits from the business. Not all profit is cash, and most businesses will typically require the owners to leave substantial cash balances within the business as working capital. When this is the case, the individual suffers a high rate of income tax on profits which never actually reach their own pocket, and so the effective tax rate they pay can be much higher than 40% or 45%.
Under a company model, however, net of corporation tax, shareholders only pay tax on drawings taken, typically in the form of dividends. Director shareholders therefore have the flexibility to decide the amount of dividends declared and need only declare sufficient dividends to fund their lifestyles, and so can manage their tax bills accordingly.
The drawback of this route is the double layer of taxation, firstly corporation tax on the profits, and secondly income tax on dividends. However, given the flexibility described above, the company structure can still be advantageous. Ultimately, any business owner who intends to draw 100% of the profits as cash is likely to be slightly better off in an unincorporated structure. However, if some profits are to be retained within the business as working capital or for reinvestment, the company model can quickly become more tax-efficient.
Implementing the incorporation – tax implications
There is still the matter of undertaking the restructuring to transfer the business from an unincorporated model to a company. Practically, the business owner will usually incorporate a new company and sell the assets of the business to the company in exchange for consideration payable to the business owner, typically an issue of shares in the new company.
From a tax perspective, the sale of the assets of the business to the company owned by the same individual is a connected party transaction and so would ordinarily be subject to Capital Gains Tax (“CGT”) at market value. However, provided that a business exists (as opposed to simply the holding of investments), the business is transferred as a going concern and all of the assets (except cash, which is treated as tax-paid money and can be retained outside of the company) are transferred to the company, the transfer should qualify for Incorporation Relief, which means the capital gain is held over into the shares issued as consideration.
Incorporation relief is only available to the extent that shares are issued as consideration. If the company pays for the assets by way of a debt owed to the shareholder, CGT is payable on this non-share element of the consideration. The issue of a debt owed to the shareholder might, however, be attractive in some scenarios; whilst a 20% CGT charge arises on the incorporation when a debt is received, the value of the loan can be drawn down tax-free, effectively as an ‘income’ stream for several years, meaning that it may not be necessary to declare dividends that are subject to income tax.
It should be noted that whilst incorporation relief can ensure that no CGT costs arise on an incorporation, there might be other taxes to consider, such as Stamp Duty Land Tax on the transfer of properties and VAT, though in many cases these should not be prohibitive.
Other considerations
As we are always keen to point out, tax should never be the main driver of any transaction or restructuring. The plans need to also fit in with the business owner’s commercial objectives. There are a number of matters that need to be considered in addition to tax liabilities in relation to the incorporation of a business. Some of these are listed below:
- The partnership or unincorporated business will cease to trade, which will trigger ‘closing year rules’ for self-assessment purposes.
- The new company will need to be formally incorporated and Articles of Association and a Shareholders’ Agreement adopted.
- A company bank account will need to be opened.
- Depending on the nature of the business, approval might need to be sought from regulatory bodies prior to the incorporation taking place.
- Employees will need to be notified of the incorporation and the implications (or lack thereof) for them, including novation of employment contracts and the application of TUPE provisions.
- Clients, suppliers, banks and insurers will need to be notified and contracts novated to the company.
Summary
Incorporating a business can, in the right circumstances, result in significant tax savings and provide the business owner with much greater control of their personal tax liabilities. It might not always be the optimal route either from a tax or commercial perspective. However, given the availability of Incorporation Relief, it is a restructuring that can be undertaken without giving rise to any immediate tax charges and should be considered by any sole trader or partnership who are suffering large income tax liabilities on profits which they never enjoy personally.
