To incorporate or not?

To incorporate or not?

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I have a client for whom I undertake some work. He is also a partner in a business in which he receives a share of profit based on his gross contribution to income. The partnership is dealt with by a large local firm of accountants.

This firm have been pushing hard to incorporate the partnership and set up two classes of share each of which would receive different levels of dividend based on the individual's contribution to turnover. It is proposed that small salaries would be paid and that non working wives would be introduced as shareholders to benefit from the dividends.

At present most of the profits are drawn out of the business in any case and this would not change in the future. Both individuals at present pay 40% tax and at least one of them will be liable to tax at 50% under the new limits.

I am doubtful that there will be any meaningful tax saving (except for the transfer of some income to the wives) and that the saving will all be NI.

I am also uncomfortable with the introduction of the wives and also that the dividends will be calculated on the income each of them generate rather than it being purely a distribution of profit.

What about employment related security legislation and income shifting?

Am I wrong to be concerned or is everyone else happily continuing with the "old ways" until it is properly banned?

Replies (27)

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By roblpm
17th Feb 2011 15:14

Tax Savings

Well I'll let someone else comment on alphabet shares etc, but there could well be a significant tax saving by transferring some shares to the wives and using their basic rate bands (assuming they are not using them). This would result in tax being paid at 0% instead of 25% for these amounts.

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Nichola Ross Martin
By Nichola Ross Martin
18th Feb 2011 10:44

All possible

Yes you can save the dreaded NICs as well as mop up any unused basic rate bands to try and avoid 50% tax. There are a large number of issues here

[Rest of comment moderated to remove blatant self promotion - see comments below. Ed]

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Euan's picture
By Euan MacLennan
18th Feb 2011 10:55

Excuse me

... but isn't Nichola Ross Martin's "All possible" response blatant self-advertisement without offering any constructive answer to the question?

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By FS Accountants
18th Feb 2011 10:55

Additional Ordinary Shares?

Alphabet shares are now not really an option. Has anyone any experience of using a second class of equity share instead. The revenues objection to alphabet shares was that they were mainly an income shifting tool because they carried no voting/ownership rights.  Is issuing another class of ordinary shares with some voting/ownership rights a workable alternative? 

 

-- FS Accountants www.fsaccountants.co.uk

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By Mallock
18th Feb 2011 11:23

Maybe not clear

Sorry, perhaps I didn't make it clear that the two classes of share would both have full voting rights. One class of share would be issued to my client and his wife and the other class would be issued to the other partner in the business and his wife.

The classes of share would be given varying rights to dividend based on the revenue brought in to the new company by each of the present partners. e.g. Individual 1 brings in 45% of the company's income and Individual 2 brings in 55%. They each hold different classes of share which will pay dividends of 45% and 55% respectively of the amount they decide to distribute. The wives of each individual will hold the same class of shares as their husband and will also receive a dividend. 

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By blok
18th Feb 2011 12:02

.

Euan, I am surprised that you are surprised!

 

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By StephenElms
21st Feb 2011 11:28

Incorporate or not?

I thinks that you should analyse the actual amount of tax and NI to be paid if the partnership incorporates.  Much to my surprise I did this exercise last week for 2 partners, each with a tax and NI bill of £30k,  Incorporation made no overall tax and N.I. saving.

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By Vaughan Blake
21st Feb 2011 12:38

Crunch the numbers then look at the bigger picture

First step is to crunch some numbers based on 2010-11, firstly using the existing ownership percentage and then inroducing the wives.  The exercise should therefore have four results:

1)  Partnership as it is at the moment.

2)  Partnership with wives.

3)  Company with existing profit shares.  Do you go for a minimum salary and the balance in dividends or vice versa?  Try both.

4)  Company with wives. Ditto re salary/dividend split

This will give an idea of the tax savings that can be acheived.  Each case is different with rate bands and national insurance etc.

Step two is to look at the bigger picture and you need to consider:

1)  Which would the client prefer assuming that the options are tax neutral? 

2)  Does Ltd liability actually provide useful protection?

3)  Can a Ltd company be useful for succession planning/employee rewarding via a share scheme?

4)  Are their bookkeeping/organisational skills up to the extra demands imposed by using a company (overdrawn loan accounts etc etc)

5)  Do they own a property used in the business?  Watch out for IHT BPR as this will be 50% or 0% in a company if left out as opposed to 100% with the partnership.

6)  Income splitting.  The big unknown.  This may hinge around the level of "work input" by the wives.

7)  Cars.  Easy to overlook but check out how they can best fund the business cars.  If they use expensive high CO2 rated cars they will be in for a shock!  Also note the new capital allowance rules for this type of car in a company (no private use) to the favorable treatment in the partnership where there is private use. 

8)  Can they use the excercise to restrucure their borrowing and make their personal mortagages "loans for the provision of capital to a Ltd company"?

9)  How much extra accountancy costs will there be?  Company accounts/P11ds/secretarial/payroll will all cost £X more.

10)  How will this affect their pensions?  Will a low salary be a problem?

11)  How far do they want to involve their wives?  Divorces can be costly!

I would be amazed if there was not a very large tax saving using a lowish salary and high dividend route, the trick is to price up all the other pros and cons to make a rational decision! 

 

 

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Nichola Ross Martin
By Nichola Ross Martin
21st Feb 2011 12:42

I'll try again

There are tax savings to be had but you need to plan properly. In reviewing a number of cases in recent weeks I have identified a huge number of key issues. Time and space does not permit discussion of these in the depth that the questioner probably requires - it took me some six hours to reseach and write and first set of analysis on this, as each partnership business is different.

When everyone is paying tax at higher rates, if you do the number crunch,  there is little difference between paying yourself a salary, or, paying divs, but the company pays marginal rate co tax or, withdrawing profits via a partnership, in fact a partnership becomes slightly cheaper in some cases as there is no ERs NICs and partners of course pay lower NICs than employees.

There is of course rather more to it than all that when you add corporate partners into the meld, or even go for a Scottish LLP, consider benefits and expenses and of course spouses. The figures are different for 50% than 40% and of course do not overlook the claw back of personal allowances when income is above £100,000.  Try sticking the figures on a spreadsheet and introducing some variables first off to see what you have, then look at tax, don't do it the otherway as otherwise you will be up all night with your spreadsheets!

If you would like assistance in appraising the pitfalls and planning points for any particular client partnership then please do contact me via, my website and I can do you a report looking at all the more diverse bits which should save you a huge amount of research time (sorry that this is self-promotion, but I would think that it OK to say that reseach takes time in this instance, and it is a shame that having done the graft I cannot share it with others who would rather save time). Other than that you can also purchase some books which give planning advice, although I cannot vouch for any on this topic currently.

Virtual tax support for accountants: www.rossmartin.co.uk

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By carnmores
21st Feb 2011 12:48

ED - once again to heavy

most people here are fairly savvy and are able to separate the wheat from the chaff - so why dont you leave it to us to decide on whether a) something is self promotion b) we care about it.

further it is not something that you yourselves are resistant to - i have asked before why you promote certain advertisers products by attaching your name to guides in their names and you answer was i f i remember ' we all have to earn a living ' or similar.

what breath taking hypocrisy!.

 

PS excellent comments Vaughan

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By Mallock
21st Feb 2011 13:37

Thanks for all the responses.

I might yet take up some of the help offered but the machanics of the calculations aren't really my problem. My client is risk adverse and would not want to do anything which could be considered to be questionable in any way: the same can't be said for his business partner.

Perhaps I should have asked the question "is this type of tax planning still going on" (obviously it is) but does  employment related securities legislation, market salary, income splitting etc have to be factored in to the relevant salary/dividend calculation.

I ask because my feeling is that these factors do have an impact and the potential tax savings are significantly reduced as a consequence. The large local firm appear to be of the opinion that these factors need be paid nothing more than lip service and large savings are there for the taking. Am I wrong?

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By shoshana
21st Feb 2011 13:48

Incorporating won't save tax/NI?

I was a little surprised to read a comment that incorporation could result in more income tax becoming payable overall - this should only happen if they plan to take full salary and bonuses in the company rather than minimum salary and the rest in dividends. The self employed pay 8% (soon to rise to 9%) on a big chunk of their profits then 1% (soon to rise on 2%) on the balance so there is a large saving to start with.

As for company cars, either buy a CO2 efficient one to get 100% FYAs and a 10% taxable benefit, or if you have a gas guzzler, keep it out of the company and claim 40p per mile (reducing to 25p after 10000 miles) for business mileage. You can even claim back input VAT on 1/3rd of this mileage claim at the rate of 1/6th if you keep your petrol VAT invoices and file them away carefully.

From 6 April the salary which can be taken NIC free rises from £5,715 to £7,075 (you can actually eek out a little more saving overall by paying a salary of £7,225 - the employees NIC arising is more than compensated by the corporation tax relief on the increased salary). Take the balance of profit as dividends.

Now in terms of income splitting, the different classes of shares may not a problem if they have full rights but HMRC are often very wary of alphabet shares and some specialist advice should be saught (not from me!). To avoid being caught by the settlement rules, it would be safer for the husband to receive the shares on incorporation and then gift some to his wife - there is a spouse exemption in the settlements legislation which is how the Joneses  (Arctic Systems) won their case at the House of Lords.

The wives should only receive a salary commensurate with their work in the company, but £7,225 per annum is only £139 per week. If they worked 5 or 6 hours per week this would probably be sufficient.

As a previous poster mentioned, the tax and NIC can be modelled on a spreadsheet. I have some I am happy to send you as a starting point if you think they would be useful - to be clear, for no charge.

Malcolm Greenbaum

Director, Greenbaum Training and Consultancy Limited

IFRS, US GAAP, UK GAAP, UK Tax and VAT

 

 

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Nichola Ross Martin
By Nichola Ross Martin
21st Feb 2011 13:54

No, I don't think that you are wrong.

Personally I would not advise anyone to get into a structure that they did not fully understand and where the outcome could be so uncertain for tax (and on a legal basis if you end up with disputing partners). There are, as you point out, endless variations of cross tax considerations.

My take is that this is all possible but you are going to have to spend a lot of time getting it right, and coming back year on year reviewing on a compliance basis, because the law moves on, and who knows what will become of small business taxation in the future; who knows if HMRC will decide that enough is enough and introduce some more anti-avoidance legislation (we already have this for capital allowances and losses, after all). This is fine if you are a legal or accounting firm because you can spend the time on the detail, if not you are going to have to pay for advice year on year and I think that sheer hassle factor of this might outweight the tax savings - the good old commercial argument, don't let tax wag the dog!

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By shoshana
21st Feb 2011 14:08

Market salary unnecessary

There is currently no problem with paying a low salary and high dividends (I would imagine 99% of companies where the directors are the shareholders do this) but as Nicola writes, we can never tell what changes lurk around the corner. Market salary can be an issue in income splitting cases (it was raised in the Artic case) but as I advised earlier, the  spouse gift exemption neutralises this.

Having said this, I would always tend to work on the assumption that the current law will remain largely in place until I read differently - if we didn't do this, then planning would be nigh on impossible.

Malcolm

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By Ken Howard
21st Feb 2011 14:16

Alphabet structure

Surely for safety's sake, there should be three share classes?  Say, A shares with all rights, split 50% each to both partners who then gift half to wives, resulting in 25-25-25-25.  Then B shares to partner A and C shares to partner B.  Dividend voted on B shares for partner A's "share" of income/profit, and same for C shares for partner B, then a dividend paid to A shares of whatever balance left over.  HMRC can't object to dividends on B and C shares because they're proportional to real work done by the partners.  HMRC can't object to dividends on A because they're full shares and amount to a lot less money than the A and B dividends.  Most of dividends will end up in partner's hands and taxed on partner, but there will be a residual also in the spouse's hands, but a lot less, just to use "some" of their basic rate band.  Once you have that structure, you've freedom to pay the partners the lion's share and then spread the balance across all the shareholders, including the wives.  I've adopted this kind of approach many times and have never had a challenge from HMRC - the key is to make sure that the "workers" or "wealth generators" get most of the money in the end commensurate with the work/effort they put in and that the spouses get something - let's face it, every little helps with a dividend to spouse due to saving the HR tax that would otherwise be paid by the husband.  As for securities legislation - has anyone had any real experience of this being applied to small owner-managed companies?  I know that the likes of Mercia and other training groups warn about it, but they also warn about dividends instead of salary and any form of spouse involvement, but from what I can tell, it's nothing but hot air and paranoia - it would be interesting to hear of any actual challenges to "normal" business situations, i.e. not the likes of IT contractor spouses which are far more obvious targets for attack.

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By carnmores
21st Feb 2011 14:57

would i be right in presuming that

it would be best not to mention wholesale gifting from spouse to spouse in any letter of advice to the partnership on the usual grounds

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By Vaughan Blake
21st Feb 2011 15:00

Company Cars

Malcolm your answer re company cars is technically spot on but....

Yes, if the directors are happy to use Fiat 500s then there is no problem.  What I find is though that my clients want to hang on to their brand new £60k Range Rovers, Jaguars, Mercs etc.  The 40p per mile doesn't go very far and the BIK is scary! 

I have a case with a total annual mileage of 7500 of which 5000 are business.  The 40p per mile only gives £2000 which barely covers the petrol and road tax.  As a partnership 2/3 of the total running costs save tax at 50%.

I do however have clients with Fiat 500s as company cars who also charge 40p per mile for using their privately owned Jag, Merc etc.  The Fiat's insurance then includes a wide range of family members.  This is a most efficient way of providing a car for the client's wife, daughter/son, au pair etc 

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Nichola Ross Martin
By Nichola Ross Martin
21st Feb 2011 15:10

Ken

Interesting angle, I know that a lot of training companies seem to exaggerate but the trouble is that if the law says something then it is foolhardy to ignore it, it is the law after all. It is difficult when HMRC do not appear to be enforcing the law for small business in fact somethings are directly in conflict with not only their own guidance but also what we see in the courts and tribunals.

I would say that before you start planning with aggressive share structures and maxing out on what you reckon that you can get away with basic wages and dividends for part-time "working" spouses is that the settlement provisions apply to any scheme or arrangement and remember that the definintion for earnings for NICs is extremely wide too. This "scheme" appears to have "remuneration" stamped on it.

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By shoshana
21st Feb 2011 15:11

Completely correct, Vaughan

I should have tempered by answer by stating that Directors are unlikely to drive around in most of the CO2 efficient cars (though one or two of them could appeal, especially with sky high petrol prices).

I would have thought it was a bit eccentric to buy a £60k Range Rover or Jag and only drive 7,500 miles per annum in it but each to their own I suppose and your point about the tax efficiency of self-employment status in this context is spot on.

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By cfield
21st Feb 2011 17:38

Goodwill, anyone?

In the midst of all this angst about whether it is more tax efficient to incorporate, everyone seems to have missed probably the biggest tax advantage of incorporation which is the goodwill trick. Being able to take profits against the credit balance on your loan a/c will save a lot more tax and NI in the first couple of years than dividends, even after gifting shares to your spouse. This assumes of course that the business is valued realistically bearing in mind that much of the goodwill attaches to the propreitors, and this element should of course be stripped out. Having said that, any business that's been trading for a couple of years will have some goodwill of its own, and it's just a matter of estimating how much. I've always found that you can get away with the annual CGT exemption at least.

With that in mind, it may be a good idea to make the wives partners ahead of incorporation so you can use up their CGT exemptions too. I'm not sure how HMRC would view this as it is blatant tax mitigation but I can't see that it's any different to gifting your spouse any other asset for capital gains tax purposes. The only major downside is loss of entrepreneurs relief on the spouse share, unless you wait another year.

Re alphabet shares, the only way HMRC can attack these is if they have different rights. So long as they have all the usual rights such as voting and entitlement to assets in a winding-up, I don't see that they are a problem. If you've got more than one class of equity share you've got to call them something, and A,B,C, etc is the obvious choice. In that sense, alphabet shares and different classes of equity are not mutually exclusive.

However, if you are going to use them as a way of varying payments according to work done, it is important that this is not pre-determined in any way when the shares are issued. The dividends payable on each class should be declared separately each and every time, not decided by the rights attaching to the shares. For example, you could always have a company policy of making dividends on B shares at least 50% of dividends on A shares, but this should be done at board level or at an AGM, not as a legal right of ownership like the coupon rate on preference shares. And just to be clear, preference shares are a definite no-no as they are simply "a right to income" and nothing else, and could therefore be attacked under Section 660a.

Income shifting is dead in the water as far as I'm aware, but as a previous poster said you should always make sure you use the gift exemption by allotting the shares to the main fee earner in the first instance and then giving some to the spouse free of charge on a stock transfer form. The only other issue, apart from making sure your dividends are properly declared and not in excess of distributable reserves, is joint bank accounts. Try to pay dividends into sole name accounts if you can, otherwise they could potentially be seen as a reservation of benefit.

As for company cars, obviously high C02 levels will attract a hefty tax charge, but you could reduce this quite a bit with a one-off capital contribution (up to £5,000). It will reduce the capital allowance but this will take a long time to come through anyway unless it qualifies for 100% in the year of purchase. However, the reduction in the BIK will be repeated each year, so after a few years it should pay for itself. Also, the contributor will be entitled to a pro-rata refund when the car is eventually sold. Private use contributions could also be tax efficient as the company will pay tax at probably 20% whilst the employee could save tax on the BIK at 40% or 50%. However, they must actually be required by the employer so don't forget the paperwork. Also, this only works if you take a large salary from your company, otherwise you would simply be shifting more dividend into the higher rate bracket and paying 25%. Might be a good way of bridging the gap between the NI lower earnings limit and your personal allowance though if you take just a notional salary and have no earned income from other sources.

Chris

 

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By carnmores
21st Feb 2011 17:52

cfield

you passed on the grass then! interesting points tho making a lot of the spouses partners with a view to immediate incorporation is surely pushing the envelope a bit far?

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By Vaughan Blake
21st Feb 2011 18:16

Goodwill - good point

Good point Chris.  I forgot this one! (Thankfully I use a checklist when I do these for my day job!)

Beware the valuation though and HMRC often argue that the goodwill attachs to the people/premises etc (depending on the trade) and cannot be valued.  If the value is downsized this will only become apparent a year or so down the line.  You may then have an overdrawn loan account to add insult to injury.

The valuation should use a sensible method and not simply ignore the trading position and equal the annual exemptions!

Also note that if the original business started after April 2002 the new company can claim a tax deduction for the goodwill write off.  If however the start date was before this there is no tax deduction on it.

If you don't get entrepreneur's relief, pay 28% CGT and the write off is not tax deductible then this can be much less attractive.  Without the tax deduction client's forget that they have to pay corporation tax on the funds before they can be used to repay the loan account.

Also on the commercial side watch out for contracts between the existing business and third parties (customers/suppliers - credit ratings/Government contracts/HP agreements/CIS certificates).  These can also trip up the unwary!

And finally!  The company can have a squeaky clean VAT number so any future visits will only go back as far as the incorporation.  Alternatively the VAT number can be transfered, the choice is yours.  Some districts will also transfer the PAYE ref without a murmur and others will tell you that this is impossible under any circumstances.

 

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By cfield
21st Feb 2011 18:29

Pushing the envelope?

I'm not sure if it is. It might sound a bit dodgy, but is it really any different to gifting shares in a listed company to your spouse just before a dividend is due, or putting a house in joint names? What's the difference? At the end of the day, a partnership belongs to the partners, and is just the same as any other property they own. If spouses are exempt from capital gains tax on gifts of other property, then why not partnerships? The fact that the spouse receiving the gift makes a killing on it soon afterwards is neither here nor there. Under the settlements legislation gifts between spouses are exempt - the House of Lords has already ruled on that.

One of my clients who operated as a sole trader has just turned it into a partnership with his wife and now wants to set up a company in April, to coincide with the new tax year. I've already told him he can have a company now, but come to think of it, if he can realistically value his business at £30k as he thinks, maybe it's a good opportunity to use his wife's CGT exemption. I know it sounds like a classic tax dodge, but I can't think of any way HMRC can object given the spouse exemption.

By the way, what does "passing on the grass" mean? Are we back on the cannabis thread by any chance?

Chris

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By carnmores
21st Feb 2011 19:36

lol yes there is something in the air tonight!

it might well depend on how many partners there are - if say there were 6 and all had spouses and they became partners pre any inc i would suggest that it stunk - it is pretty clear that they are unlikely to have contributed anything to the partnership and incorporation meant that there was no downside for them - it was simply an attempt to evade tax - anyway thier salaries might be dissallowed - although i hate alphabet shares in this case it is possible that they could be a less distasteful approach 

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By cfield
21st Feb 2011 21:41

Good points Vaughan

Yes, there are a few traps for the unwary with goodwill valuations. We always get our clients to put a clause in their incorporation agreements allowing a clawback if the sale value is subsequently found to be over-stated.

With smaller clients they never seem to be a problem though. We usually use a round sum figure as such values can be hard to define, but even when you strip out goodwill relating to the owners/location, there is bound to be some for things like clients lists, advertising, supplier contracts, staff training, website, etc. Who is to say how much these things are worth? I've never known HMRC to challenge anything below £100k, although perhaps I've just been lucky. £10-£30k is more normal for small clients anyway.

The intangibles regime is almost too good to be true. I still find it hard to believe it applies when there are related parties involved, as in incorporations. How long should you amortise over? FRS 10 says no more than 20 years unless you can prove it should be longer, but why would anyone want to? We always try to get away with much less just to expedite the tax deduction. Average life of a client account seems a good measure.

Shame about the pre April 2002 businesses, but I think that only applies to related parties.

Chris

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By chatman
11th Mar 2011 19:53

Form 42

If the shares are gifted to the wife after incorporation, is it reportable on Form 42? 

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By cfield
11th Mar 2011 23:15

Form 42

Only relates to new shares as far as I'm aware, not existing shares gifted to someone else.

Chris

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