Mark Lee

A new landscape

This year’s Budget and Finance Act have, I believe, totally changed the landscape as regards the taxation of smaller businesses.  This is despite the fact that the tax changes announced to take effect from this year and in the near future do not sit well alongside the incentives to incorporate that were first introduced by Finance Act 2002.

This article is going to worry many people. That is not my intent and I hope that my outline explanations of the key issues will help in clarifying what is going on and why a head in the sand approach is dangerous.

I will start by briefly analysing the new environment in which we are operating and explain why I believe that disincorporation is likely to be become more popular in the near future.  I will then highlight some of the practical issues that we cannot afford to ignore.

Where are we now?

This is not the place to debate the inconsistency of Government policy as regards the taxation of smaller companies or the weasel words that have been used to ‘justify’ the conflicting tax changes in recent years.  When the 2002 changes were first announced the professional bodies and other commentators all anticipated the predictable behavioural changes of existing small businesses.  Such warnings were dismissed presumably because the Government’s own advisers had overlooked the obvious. Subsequent tax changes have attempted to remedy the oversight and we have now come almost full circle.

Let us start by noting that over the last five years it has been almost standard practice to encourage smaller (indeed all) new businesses to start life as a limited company – other than, perhaps, where losses were anticipated and could be offset against pre-incorporation income. 

The question we must now ask though is whether all small traders can still expect to pay less tax if they operate as a limited company than as an unincorporated trader?

That is a loaded question of course. And indeed it’s not even the right question to ask. Although clients want to pay the least amount of tax they can do so (within the law) they are not generally happy if the additional fees they have to pay exceed the hoped for tax saving. So the real question is: Under what scenario will clients have most money left in their pockets after both tax and fees have been paid?

To incorporate or to disincorporate?

I have been writing and lecturing on this and related issues for many years. Indeed I am the author of Tolley’s Tax Digest on Incorporation and I was quite thrilled to learn that Hansard records the Paymaster General, Dawn Primarolo, giving the publication an unintended plug on 27 April 2004.  She said: “As businesses consider whether to be incorporated, they, and presumably their advisers, may read Tolley's Tax Digest, which lists a huge number of points about the tax consequences for or the obligations on someone who is self-employed, in a partnership or who chooses to incorporate.”

In my talks, books and articles I have long stressed that it can be counter-productive to base one’s choice of business structure solely on simplistic comparisons of tax liabilities.  Such comparisons require various assumptions to be made and the ‘best’ solution this year might not be the ‘best’ solution next year.  But of course the combination of tax changes introduced in 2002 was such that the arguments in favour of incorporation became almost over-powering.  The prospective tax changes announced this year however mean the pendulum is starting to swing the other way.

I will let you explore the alternative calculations and forecasts, perhaps using one of the commercially available spreadsheet programmes, to determine the answer to the incorporation question in specific cases.  What I intend to do here is to warn you against making hasty decisions to disincorporate clients when you conclude that this would be preferable all round.  That may happen this year, next year or the year after.  Disincorporation won’t be as widespread as has been incorporation but it will become far more prevalent than it has been in recent years.

So what? What’s the big deal? It can’t be a big issue as we’re talking about small businesses here. How difficult can it be to close down a company and to start trading as a sole trader or partnership?

Well let’s start by noting that there are no concessions or reliefs available to help facilitate disincorporation (in stark contrast to the position when it comes to incorporation).

Consultation

Twenty years ago (on 2 July 1987 to be precise) the DTI and Inland Revenue jointly published a 60 page consultative document on Disincorporation. Sadly I might be one of the only people who still has a copy. The stated intention at the time was to bring forward recommendations for changing the law so as to 'make it easier for businesses to switch from trading as limited companies to sole traders or partnerships' and to reduce 'the tax and other cost penalties which currently attach to disincorporation and effectively rule it out as a practical option.' Yes, that was specifically noted as the rationale for the document.  So what has changed over the last two decades? Well, quite simply and so far as I can tell, there has been no effort whatsoever to make any changes that would facilitate disincorporation. 

Two decades ago the main obstacle to disincorporation was that the tax system did not recognise the need for provisions to facilitate the move away from a corporate structure.  More recently, just seven years ago, on 17 March 2000, Hansard records that Dawn Primarolo told Parliament that 'The Government have no plans to change the tax rules applying to disincorporation. Given the likely complexity, and length, of legislation needed to change the tax law affecting disincorporation there would need to be a strong case for making a change.' She continued, somewhat surprisingly, to state that 'Officials have consulted with representative bodies and other interested parties, but no strong case for change has so far emerged.'

And that’s where we still are now. There has, so far as I am aware, been not one change to company law or tax law to facilitate disincorporation over the last twenty years.

What then are the main tax problems that can arise? 

Capital gains issues

The most important trap will be relevant if the company owns certain assets (including goodwill) that would be subject to the tax if the business were sold to a third party. In the first instance tax law dictates that the company is treated as if it were selling to a third party. Thus you will need to consider the current market value of all assets, including goodwill, owned by the company.  It is important to appreciate that goodwill can exist even if no value is attributed to it on the balance sheet. Equally the market value will often be much higher than the cost of any goodwill reflected on the balance sheet.

So there is a possibility that the company will be liable to pay corporation tax on what are called ‘deemed’ capital gains.

Income tax issues

Equally shareholders are, as we know, liable to pay tax on any monies or assets that they withdraw from the company. This rule applies equally if the company disincorporates and transfers any assets, including goodwill, to the shareholders. Thus they could have to pay tax by reference to the market value of the company’s goodwill and any other assets that they then use to operate the business as a sole trader or in partnership. 

There is also a danger that any transfer of assets to director shareholders by the company could be subject to the ‘benefit in kind’ rules such that income tax and National Insurance Contributions become payable thereon.

The smallest of companies

Is there really cause to worry about these sort of things when the company concerned is effectively just a one-man band with no material assets? It depends.  Plenty of such companies have goodwill on their balance sheets, perhaps as a result of tax planning advice at the time of incorporation. You cannot simply ignore such an asset when the company is disincorporated. And the current market value may well be very different to the value that was placed on it at the time of incorporation.

It is equally possible for goodwill to exist even if it has not been recognised on the balance sheet. This will particularly be the case if the subsequent business will complete contracts originally obtained by the company; use the same business name, adverts, client lists or any other intangible assets owned by the company.

Conclusion

The position is not totally bleak of course. There are legitimate ways to untangle the position and it will often be possible to disincorporate a company without undue tax cost.  But the key point is to consider all of the relevant factors and to plan ahead. If you attempt to disincorporate and then try to legitimise things afterwards you only have yourself to blame if you suffer unexpected tax charges or become the subject of a professional negligence claim.

Article Added Sunday, 01 July 2007 | 3096 Hits

Your attention is drawn to the disclaimer on this site, which applies to the content in this section.