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Taxation of Unincorporated Businesses by Malcolm James

Malcolm James, author of ‘Taxation of Unincorporated Businesses’ provides an introduction to some important tax issues upon the incorporation of a business.

Cessation

There will be a cessation of the unincorporated business and the closing year basis period rules (ITTOIA 205, s 202(1)) will apply. The date of cessation should be chosen carefully to avoid a large assessment in the tax year of cessation. It is also necessary to take the cashflow consequences of cessation into account. For example, if a sole trader has an accounting date of 30 June, there is a delay of 19 months between the end of the accounting period and the balancing payment of the related tax liability. If an unincorporated business were to incorporate on 1 April 2005, the basis period for 2004/05 would run from 1 July 2003 to 31 March 2005, i.e. 21 months. There will therefore be a large balancing payment on 31 January 2006 and, from 1 April 2005 the sole trader will not be generating any gross income out of which to fund the tax liability; his income will solely consist of remuneration and dividends received from the company.

Transfer of Assets

A balancing charge or allowance may arise on the transfer of assets to the company. The disposal value to be brought into the final computation of the unincorporated business in respect of plant and machinery will be either the actual proceeds or the market value at the date of incorporation. The disposal value in respect of cars costing over £12,000 will be the market value at the date of incorporation (CAA 2001, s 79). The taxpayer may make an election under CAA 2001, s 266 to transfer assets at tax written down value. A similar election may be made on the transfer of an industrial building under CAA 2001, s 569.

Transfer of Trading Stock

Trading stock and professional work-in-progress are generally deemed to be transferred at market value (ITTOIA 2005, s 177), but an election may be made to use the greater of the sale proceeds and book value (s 178(1)-(4)). Professional work‐in‐progress may be transferred on a similar basis, provided that the excess of market value or sale proceeds over cost is treated as a post-cessation receipt (s 184(2)). HMRC will normally accept the value attributed to work-in-progress, unless it is clearly ‘illusory, colourable or fraudulent’ (ICAEW Guidance note Tax 7/95).

Losses

A loss arising in the last 12 months of the unincorporated business may be carried back under ICTA 1988, s 388. Unrelieved trading losses at the date of cessation may be relieved against income received by the taxpayer from his company, i.e. remuneration and dividends.

Transfer of Chargeable Assets

Chargeable gains will arise on the transfer of chargeable assets to the company, but incorporation relief (TCGA 1992, s 162) or gift relief (TCGA 1992, s 165) may be claimed on the transfer. Advantages of claiming relief under TCGA 1992, s 165 are that it is not necessary to transfer all non-cash assets into the company nor for the company to issue shares in exchange for the assets. A company can therefore be set up with minimal share capital. The disadvantage of claiming gift relief is that the gains arising on the transfer of the assets are deducted from their base cost in the company, which will therefore be no higher than the original cost to the unincorporated business. Where relief is claimed under TCGA 1992, s 162 the gains on the transfer of the assets are deducted from the base cost of the shares received by the sole trader or partners, therefore the base cost of the assets on a subsequent disposal by the company will be their market value at the date of incorporation. Conversely, where relief is claimed under TCGA 1992, s 165, the base cost of the shares will be the total original base costs of the assets which were transferred into the company, whereas, if relief is claimed under TCGA 1992, s 162 the base cost of the shares will be their nominal value.

It may not be advantageous to claim relief under TCGA 1992, s 162 or s 165 if any gains on assets transferred qualify for maximum taper relief. In this case the base cost of the assets in the company will be their market value at incorporation and the base cost of the shares will be their nominal value. The preferred approach will depend on the sole trader’s circumstances at the time of incorporation and whether it is anticipated that the company might be sold to a third party within the foreseeable future.

If the sole trader owns the business premises from which the business operates, he will generally wish to retain personal ownership after incorporation. This will therefore mean that it is not possible to claim relief under TCGA 1992, s 162.

Transfer of Goodwill

Since April 2002, no stamp duty has been payable on the transfer of goodwill.

Since CGT will often be payable at an effective rate of 10% it may be advisable to transfer goodwill to the company for its full market value. For the purpose of taper relief, HMRC will generally treat the ownership period starting at the commencement of trading, and any gain is deemed to accrue evenly over the period of ownership. In partnerships, the ownership period commences on the date that a partner joins the partnership, regardless of any changes in profit sharing arrangements where goodwill is not recognised as an asset on the balance sheet and is given no value in dealings between the partners (SP D12 para. 12).

HM Revenue & Customs take the view that the element of goodwill which is personal to an individual, i.e. his reputation and skills, is not capable of sale. It can be exploited, but, and if there is more than one shareholder, it may be advisable for the company to enter into a restrictive covenant with an individual with particular skills to prevent the exploitation of the personal goodwill elsewhere. Any payment made by the company in return for the restrictive covenant is taxable as employment income.

The goodwill acquired by the company will not qualify for relief because it has been acquired from a connected party (FA 2002, Sch 29).

Stamp Duty Land Tax

Stamp duty land tax is payable on the market value transfer of land and buildings, even if no consideration is given (FA 2003, s 53), provided that the value exceeds the threshold of £150,000.

Inheritance Tax

Business assets owned by a sole trader qualify for 100% business property relief.

The availability of relief after incorporation should be considered. For example, if a business property is retained by the sole trader it will attract relief only if he controls the company and relief will only be at a rate of 50%.

Value Added Tax

No VAT is payable on the transfer if it is treated as a transfer of a going concern (VATA 1994, s 49). The company may take over the registration of the unincorporated business if an application is made. Otherwise VAT is payable on the transfer, but this is generally only a cash flow problem.

October 2005

Malcolm James

Malcolm James is a Senior Lecturer in Accounting and Taxation at the University of Wales Institute, Cardiff.

The above article is adapted from ‘Taxation of Unincorporated Businesses’ published by Spiramus Press Ltd. To order Taxation of Unincorporated Businesses click here