Incorporation: Points To Consider

The question as to whether a business should operate through a limited company is often dictated by the tax implications, though not always – insulation of the individual from commercial risks is often reason enough.

The term ‘incorporation’ can also include transferring a business (usually a partnership) into a limited liability partnership (LLP) as they, like limited companies, are bodies corporate with a separate legal identity.

However, LLPs are treated exactly the same as ordinary partnerships for tax purposes, i.e., they are transparent with the partners (or ‘members’ as LLP partners are known) taxed on their profit or capital shares. When a partnership becomes an LLP, it is essentially a non-event for tax purposes, even though a new legal entity is operating the trade; however, becoming a limited company is very much an event for tax purposes.

Capital Gains Tax

The main issue is that when a sole trader, or partnership, transfers business assets into a limited company, it is treated as a disposal for capital gains tax (CGT) purposes on the owner, even though they own the recipient company and the business is one of a going concern.

The default position, assuming all assets have gone across to the company, is that the notional capital gain will be rolled over into the value of the shares, which the owner will receive in consideration. However, this default relief – ‘incorporation relief’ (under TCGA 1992, s 162) – can be disapplied and the CGT paid instead.

Incorporation relief is quite an unusual relief. First, it is automatic (unless disapplied); second, it applies to ‘businesses’ and not just trades as required by the other CGT reliefs. This is useful for those businesses which might resemble more of an investment than trade, such as a rental property portfolio; whilst renting land will never be a trade, it might be a business if it is operating as such when sufficient hours and activity are provided by the owner.

The main criterion for TCGA 1992, s 162 relief is that all assets (except cash) go into the company; if that is not the case, section 162 relief is not available and CGT will be chargeable. However, one reason why business owners might disapply the relief is because they do not want a latent gain with the shares; they may prefer to ‘have it over with’, pay the tax at the current rate and, more importantly, claim business asset disposal relief if they can.

If TCGA 1992, s 162 is not activated and the disposal remains chargeable, the consideration received by the business owner will be mainly in the form of a directors’ loan account; this can then be drawn down, tax-free, whenever the company has the funds to make repayments. It is therefore important to value the business assets properly, as an overvalued sale may lead to a greater loan account, with corresponding ‘excess’ drawdowns being taxable as dividends.

Stamp Duty Land Tax, etc.

The tax which may be of most concern is stamp duty land tax (SDLT) in England and Northern Ireland (or its devolved equivalents); under FA 2003, s 53, the transfer of land or buildings to a connected company attracts a deemed charge based on market value consideration; SDLT must be paid within 14 days of completion, so it is a major strain on cashflow.

Incorporating a family partnership, all of whose partners are related or are the same people as the subsequent shareholders, can potentially avoid the charge via provisions in FA 2003, Sch 15; however, there are anti-avoidance provisions within FA 2003, Sch 15, para 17A acting as an effective exit charge within the first three years; also, the antiavoidance rule in FA 2003, s 75A is a much wider provision striking down any arrangement made to avoid SDLT. A legitimate business partnership looking to incorporate for genuine commercial reasons should have nothing to fear, but SDLT is a complicated area, and an expensive one if you get it wrong.

Practical Tip

When considering incorporation, factor in the CGT or SDLT cost of doing so, as well as the company and individual’s tax position going forward. If faced with a high upfront cost for those taxes, the potential long-term savings of incorporation may still make it a worthwhile cost.