David Anderson explains why businesses might consider incorporating a limited company to help them make substantial tax savings in the future.

From little acorns grow large oak trees and so it is that larger businesses start off small, often as a sole trader, a partnership or limited liability partnership (LLP). However there are some advantages to firms incorporating – that is, becoming a limited company, not least of which are the tax advantages as well as the limited liability and protection from creditors.

Tax savings

No business wants to pay more tax than they have to and by incorporating a business significant income-tax savings can be achieved by using a properly structured company. This is based on the fact that when you transfer your business to a limited company, you are viewed legally as personally selling it to the new limited company. For tax purposes, this is the same whether you are a sole trader, a partnership or a LLP.

Part of the process involves the ‘sale’ of the business to the new limited company that’s been set up. The question many ask is ‘what is the price I am deemed to be selling at?’ The answer is simple, what you could reasonably get for your business in the open market.

You may already have had offers or you could get a valuation from a business transfer agent. The valuation 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.

The main thing is to have a ball-park value, which may be needed for tax purposes. If you set up the business from scratch, there will usually be a significant capital gain as you will have paid almost nothing for it.

Luckily, you won’t normally have to pay capital gains tax when you incorporate your business. This is because you can opt to have the gain rolled over into the value of the shares in the new company – the shares in the new company will have the same value as your business had originally, in most cases almost nothing.

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 and not £1m.

Obviously, if you subsequently sell the shares in the company you will pay capital gains tax on the whole sale price and not on the sale price less £1m.

Some may decide they don’t want to pay tax later when they really only sold the business to themselves in the first place, and got no cash in return.

That’s a fair point and one based on the conventional approach, if they generally followed advice from their accountants. Here, they will pay capital gains tax when they eventually sell the shares in the company; so if they finally sell the shares for £2m they will have a capital gain of £2m. This way they have stronger cashflow, as they do not pay any capital gains tax until they receive hard cash from a buyer. However, all money they take out from the company – either as a salary or as a dividend – is taxed in their hands to income tax.

Another option is to not opt for the exemption at the time of the ‘sale’ to the newly formed company and, instead, pay the capital gains tax up front. Therefore, in the example above, you pay capital gains tax on the £1m gain at 10% – Entrepreneurs’ Relief should apply – ie, £100,000.

Moving on, the company will pay corporation tax on its profits. This means, roughly speaking, that on the future profits of £1m you extract from the company you will pay a total of 20% corporation tax at today’s rates, plus the 10% capital gains tax you’ve already paid – 30% tax in total. However, and this is the big plus, you avoid both income tax and National Insurance on the £1m you extract from the company going forward.

Naturally when the £1m loan is repaid you’ll then extract profits from the company by way of a salary and dividend. The tax advantages, however, then end.

All partners in the business being sold can participate; they will all sell to the limited company and so will all have a debt due to them from the company. Normally, their debts will all be paid down equally by the company.

And in terms of VAT, none should be due on the sale. You can opt to either keep your VAT number, or the limited company can apply for a new VAT number. It may be easier to keep your VAT number, though you continue to be liable for any historic issues with it.

There will be fees for the transaction but, normally, the tax savings make the fees a small outlay. You will need to involve an accountant and a solicitor and the fees are also tax deductible.

The risks

As with anything, there are risks and 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 opt 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. This is a real risk in structuring your incorporation this way. But, get it right, and you’ll be quids in.

David Anderson is a solicitor at Sykes Anderson Perry

Image courtesy of Shutterstock/ Singkham