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Incorporation - why bother?

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21st Jul 2011
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NOTE: This article has been updated as at October 2015

Pre the Summer Budget 2015 the usual practice was to consider incorporation if a business' profit was in the region of £40,000; post the Budget that has all changed. However, there remain other benefits for incorporation. Jennifer Adams lists the benefits that can be achieved detailing the practical issues that need to be considered before a business takes the plunge and incorporates.

Benefits

  • Reduction in tax bill - this article does not intend to cover the calculation but there are potential tax savings for years to 2015/16. Following the Summer Budget 2015 and the Chancellor's shock announcement on dividend taxation that benefit has been somewhat eroded. Details can be found in Rebecca Bennyworth’s article 'Bennyworth's view on business incorporation'.
  • Limited liability - before the benefit in tax reduction this was the main reason for incorporation because should a company fail the liability of the shareholder is supposedly limited to the amount unpaid on the shares (if any). However, banks now demand personal guarantees of directors such that the value of Limited liability has eroded. However, the word ‘Limited’ may provide enhanced status.
  • Different categories of shares can enable different levels of payment to be allocated; advantage being taken of the different personal tax circumstances of individual shareholders.
  • Dividend waivers enable transfer of income - possibly from a higher rate tax payer to lower rate. Not possible to transfer income of self-employed unless a partnership is formed.
  • IHT Planning - a company enables greater flexibility; on death the company continues to exist as a separate legal entity.
  • Depending upon the type of business it might prove easier to sell shares rather than the business and business assets if not a Limited company.
  • A director can borrow from the company with no need to attend a bank interview or pay high credit card/loan interest. Shareholder consent is needed under Companies Act 2006 if the loan exceeds £10,000 (s207 - small amounts limit) and there is a corporation tax charge of 25% if the loan remains unpaid nine months after the year end (s455 CTA 2010). If the loan is in excess of £5,000 and is interest-free or less than 4% there will be a taxable benefit in kind charge for the director and an NIC charge for the company.
  •  
  • Tax free employee benefits and incentives can be provided with the company obtaining tax relief thereon - not possible for the self-employed employer
  • Where the business property is held outside of the company in the directors name the director can extract funds from the company in the form of rent - no PAYE or NIC issues. There will usually be a mortgage such that rental income will ensure immediate tax relief for interest paid. No Entrepreneurs Relief is due on the sale of the property as it will be deemed an investment property.
  • Overlap relief available on cessation of self-employed trade.
  • Transfer of trading loss - relieved against salary then against dividends so long as business exchanged for shares. At least 75% of the shares of company must be retained by the shareholder throughout the tax year in which the loss is relieved. (S86 ITA 2007)

Practical issues

  • Be careful to calculate best date for cessation of self-employment - choosing the wrong date may increase tax liability for the final year.
  • Some companies in regulated industries may be required to apply for new licences as the status of the business has changed.
  • Consider whether it would be more beneficial for cars to be held in the director’s personal name outside of the company - calculation as to benefit in kind and Capital Allowance etc. needed. Company cars are no longer tax efficient now that they must be pooled with other plant so unless the car is of low emission the figures will probably show that it is best to keep car out of company. Will leasing the car be an alternative?
  • Turnover of a company in excess of £6.5m requires audited accounts; this could affect small businesses with large turnovers but low margins, e.g. second-hand car dealers; no such requirement for self-employed.
  • Care is needed where there is the prospect of the shares being transferred or disposed of within two years of incorporation (Business Property Relief)
  • IR 35 ‘personal service’ legislation issues for ‘knowledge based’ businesses.
  • Consideration is needed as to the method of transfer of business i.e. via use of ‘Incorporation’ relief (s162 TCGA 1992) or ‘Hold Over’ relief (s165 TCGA 1992) or to disapply both reliefs. ‘Hold over relief’ is automatically applied by HMRC if the relevant criteria are met therefore suggest write to HMRC confirming position. Many traders are choosing to disapply both reliefs and electing instead to be subject to CGT on the disposal of the business to the company, the proceeds being left as a director’s loan. If the business was set up post 1 April 2002 the cost for goodwill is allowed to be amortised in accordance with accounting practice against the company's profits; if the goodwill was created pre 1 April 2002 no relief is allowed. The owner can claim Entrepreneurs’ relief on the sale of the business and should full relief not be possible tax is charged at the beneficial rate of 10%.
  • The most difficult issue to deal with is the valuation of goodwill - best to use a specialist valuer.

Further reading

Jennifer Adams FCIS TEP ATT(Fellow) is Associate Editor of AccountingWEB. A freelance writer specialising in tax and company secretarial issues she is also proprietor of Naldrett Accountants

Replies (22)

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By robbieb666
22nd Jul 2011 10:54

Incorporation

One of the main issues I have encountered is that many sole traders/partners are just not the right type of people to run a limited company. They continue to treat monies as their own rather than the limited companies no matter how many times you tell them not to do this!!!

 

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By bduncan
22nd Jul 2011 11:03

Errors

There are several errors above. One for starters is:

Different categories of shares can enable different levels of payment to be allocated; advantage being taken of the different personal tax circumstances of individual directors.  - Directors do not receive dividends shareholders do.

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By jon_griffey
22nd Jul 2011 11:05

Don't touch with a bargepole
I quite agree with robbie. There are some clients - quite a lot actually who should not be allowed anywhere near a limited company. To my mind if you are to trade as a company then you must do it properly - proper books, minuted dividends, appropriate expenses, dispensations. I know there are firms out there that incorporate virtually all clients - they must recklessly disregard the formalities.

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By robbieb666
22nd Jul 2011 11:25

Agreed

I agree Jon - i know firms - mainly smaller firms that have incorporated virtually all their clients but have not given them any guidance at all.

Some of the advice out there is shocking!!!

 

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By AnnaKournikovasKnickers
22nd Jul 2011 11:26

Incorporation pros & cons

As an IFA, I would make two points;Firstly, a SSAS pension has advantages over SIPPS and as you are aware, business owners  can have a SIPP but unless they are controlling directors  they cannot have a SSAS.

 

Secondly, I have just been instructed to incorporate a rugby club (I shall do so as a CIC, obviously) as the English RFU have memo'd their members (apparently*) to this effect. So there would appear to be other extraneous non accounting reasons for incorporation not covered in this article.

*P.S. If anyone knows why I would be interested to know but, hey, I'm not going to argue.

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By grooney
22nd Jul 2011 12:18

Incorporation of Rugby Clubs

This is all to do with limiting the exposure of members to risk.  As a members club the individual members are all collectively in the frame if, for example, someone sues the club for injury on their premises.  

In recent years some clubs have faced massive financial claims which would wipe them out and then take a chunk out of the member's personal assets too.

The RFU are advising members clubs to incorporate (limited by Guarantee) to reduce the risk to individual members and their personal assets.

 

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By joereid
22nd Jul 2011 12:31

Incorporation why bother - Pratical issues

Can you develop the point about being careful to calculate the best date for cessation of self-employment, as choosing the wrong date may increase tax liability for the final year.

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John Stokdyk, AccountingWEB head of insight
By John Stokdyk
22nd Jul 2011 12:37

"Shareholders" amended in text

The article has been adjusted as you suggested, bduncan. Jennifer wrote the piece from the perspective of a sole trader who was thinking about going the incorporation route, and made the assumption she was dealing with director/shareholders.

If you could elaborate any of the other mistakes you mentioned in your comment, we will examine them with the author to ensure the article is accurate.

@joereid - you raise an interesting point about the cessation date, Jennifer has her hands full with a handful of other articles I've asked her to do aside from brief comments here, she may not be able to follow up with a more detailed examination of the tax issues. But I'll put it on our list to see if we can get someone else to do a quick digest.

However, if you click the Incorporation tag, you should find a pretty comprehensive collection of both Any Answers threads and technical articles discussing the issue in more detail. Or you can search for "incorporation cessation date" , which produces a few relevant conversations.

Thanks for the prod - I'll put it on our list and see if we can get someone to do a quick digest.

 

 

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Rebecca Benneyworth profile image
By Rebecca Benneyworth
22nd Jul 2011 13:05

Careful thought

Jennifer's article does emphasise that craeful thought is needed. To confirm the above comments, my acid test is the phrase "What do you mean, it's not my money?" If that is the sort of thing your client would say then you are buying a whole box of trouble. Similarly, clients who think a whole year's worth of records fit on one side of A4 are not a good bet for limited company status. I learned the hard way with a couple of clients many years ago, and I now reckon I have a good "nose" for those who should stay away from it!

One barrier to incorporation I might mention. If the unincorporated business is into the bank for a lot, you may find that moving that borrowing to a limited company entity will not actually be possible, even with director personal guarantees and second charge on the house. In some cases the bank just says no.

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By jon_griffey
22nd Jul 2011 16:19

Cessation date
joereid - this I expect refers to the issue of overlap profits etc. If you have a client with an accounting date other than 5 April/31 March then you have an issue. The worst one is usually 30 April year end. If you are not careful and pick the date of cessation late in the tax year, say 31 March 2011 then the final year's self-assessment (2010/11) will be based on the year ended 30 April 2010 + 11 months to 31 March 2011 LESS overlap relief. Often overlap relief is minimal and so the client gets taxed on 23 months of profit - maybe at 50%. And you told them that going ltd would save them tax! In this situation it would be better to choose a cessation date early in the tax year, say 30 April 2011.

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John Stokdyk, AccountingWEB head of insight
By John Stokdyk
22nd Jul 2011 17:15

Thanks for coming to our rescue!

Much appreciated, Jon.

I still reckon there's an article in the subject, but you've managed to do a pretty good summary in one paragraph.

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By joereid
22nd Jul 2011 18:07

Cessation Date

Jon,

Many thanks for your comments.

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Rebecca Benneyworth profile image
By Rebecca Benneyworth
22nd Jul 2011 18:10

Overlap - my pet hate

Possibly even worse is incorporating a client who has reduced profits since he started. So a 30 April accounting date client who had profits of £120,000 in year 1, and has £40,000 now could have a loss due to overlap relief of around £70,000 on cessation as the profits of the final year are not big enough to soak up all of the overlap. Terminal loss releif might help but it's another case of watch out. In this case cessation on 31 March, bringing 23 months profits into the final period might help a bit.

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By twickers
24th Jul 2011 11:07

member clubs- unaware of potential liabilty
you should expand on this brief article /a longer one would possibly help those who sign up as members of everything from social club to political associations without understanding the extent of liability you have referred to/even less when proudly they accept appointment to management ? of what they
are legally undertaking. ( I tried with local associations (mistake the wife was chairman of one of them)
The tax implications including CGT are rarely understood.

twickers

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By ianmckechnie
25th Jul 2011 17:57

Incorporation - why bother

I'd like to see the calculation underlying the statement that the break-even for incorporation is £ 50,000.  Unless an extortionate accountancy bill is factored in, I think the figure is quite a bit lower..........

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Nichola Ross Martin
By Nichola Ross Martin
26th Jul 2011 18:17

Just to add:

Limited liability: the corporate veil is notoriously difficult to pierce, so you can trade comfortable in the knowledge that you can mis-sell your credentials and still escape your creditors (see checkout Williams v Natural Life Healthfoods to see how the court will resist piercing).

I say keep it simple, so you will really want to avoid the following:

Different categories of shares: best avoided unless you fully understand the consequences, as "there be dragons and you might get burnt". Beware of coming unstuck see HMRC examples in Form 42 guidance, and the wide definition of earnings in the NICs rules and don't overlook what happens when your shareholders all have different shares and fall out and you have not put in some suitable provisions to deal with this in your articles, and of course the settlement provisions.

Dividend waivers: more dragons...this time mainly the settlement provisions, but in many cases the plan goes badly wrong with folk trying to back date waivers (fraudulent activities?) or they simply fail to execute them property.

IHT planning: watch out for death! No market value uplift for property held in a company, bad result for outstanding directors loans, and of course only 50% BPA for property rented to the business.

Transfer of a trading loss - generally not recommended to incorporate if you are making losses from an insolvency angle as it this potentially puts directors in a very compromised position from day 1.

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

 

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Norman Younger
By Norman Younger
26th Jul 2011 20:29

Incorporation

As a company formation agent I find that there is one argument that sways it for many people . Simply put , it could be the best insurance policy you ever take out. 

We live in an ever increasingly litigous society and a claimant will take aim at the easiest target. Sole trader with a home , saving and investments ?  - sitting duck. Corporate veil in the way is like a suit of armour.

 

 

 

 

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By Vaughan Blake
27th Jul 2011 17:56

Cars, cars, cars

This area often swings the decision away from a ltd company.

Take a "management consultant" with a £50K profit.  Then crunch the incorp numbers and see the tax saving.  Then work out how with a company  he is going to fund his Jaguar XKR list price £60K and bought second hand for £30k.  Business use 25k miles being 95% (uses his Porsche Coxster at the weekends)

Then deduct the extra cost this, plus extra accountancy from the tax saving.  Still worthwhile?  Then consider incorporation.

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By jon_griffey
28th Jul 2011 09:39

Expensive cars
Vaughan makes a very important point. If the client likes expensive cars, especially second hand ones then a ltd co makes it very inefficient. You get the double whammy of high benefit in kind and a 10% pool. An increasingly interesting vehicle is the LLP. As well as limited liability, it is great for avoiding the company car and 10% pool (i.e. 10% pool not so painful with private use and balancing adjustment) and drawings are much more flexible than with a company. Ideal for many clients. When our firim incorporated we found it much more appealing to go LLP rather than Ltd.

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John Stokdyk, AccountingWEB head of insight
By John Stokdyk
01st Aug 2011 12:46

Something for the car fans...

Thanks for your comments Jon and Vaughn, and it's interesting to note the influence your taste in vehicles can have on the incorporation debate!

Just so you know, as part of our relauch this week, we're planning to extend the number of discussiong groups, including one for those interested in cars and company cars. I hope you have time to join us there to share your insights!

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By Malcolm Veall
02nd Aug 2011 09:39

Small Co.s just don't have cars in them

John,

The last thing I would want to do is pour cold water on a new initiative but...

Most of us small practice GPs would not join a cars group if our client base is largely Ltd companies - because the existing car tax regime means that our clients just don't have cars in their small companies at all.  Consequently the group is certain to be of interest only to accountants advising large companies on employee/director reward packages.

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By mrclarky
03rd Aug 2011 17:09

why don't people look at Limited liability partnership?

Agree with all the comments about dragons and Alphabet shares and the practical aspects but for a number of clients worried about limited liability consider LLPs

TransparentAll members get entrepreneurs relief not just 5% shareholdersNo nasty employee share issuesSingle layer of tax on sale and acquirer gets assets rebasedNIC savings on cars etc not to be sneezed at

My view is that an awful lot of businesses would be better trading in a LLP then in a company.

 

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