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Forbes Dawson by Mark McLaughlin ATII TEP

Mark McLaughlin, consultant to Forbes Dawson, Chartered Tax Advisers in Manchester, considers the tax advantages and disadvantages of incorporating sole trader or partnership businesses and operating as a limited company.

Why incorporate?

Recent changes to the tax system have led to many self-employed individuals and partnerships incorporating their businesses. There has even been talk of a ‘hidden agenda’ by the Government of pushing businesses towards operating through the medium of a limited company by increasing the tax incentives to do so. If this is true, newly incorporated business face an anxious wait for further changes to the tax system to find out why.

Some of the advantages and disadvantages of incorporating the business are considered below. It is worth mentioning that the Inland Revenue can seek to reclassify self-employed individuals as employees, if that reflects the reality of the relationship with a client or customer. There is also legislation (known as “IR35” after the Inland Revenue Press Release announcing the provisions) to prevent taxpayers forming companies to do the work, in order to avoid reclassification as employees. For the purposes of this article, it is therefore assumed that all sole proprietors and partnerships reading it are genuinely self-employed persons, and that their tax status is not open to challenge by the Inland Revenue.

The advantages…

Incorporation gives rise to a number of planning opportunities, including the following:

• Company profits are taxable at lower rates than the 40% higher rate of personal tax. The gap between these tax rates was further widened from 1 April 2002 with the introduction of a 0% starting rate of corporation tax on taxable profits up to £10,000, together with a reduction on the small companies rate from 20% to 19%.

• The profits of a limited company usually need to be extracted by the business owner. The main forms of profit extraction are salary and dividends. One or a combination of these can result in a lower rate of tax overall compared with a similar amount of profits taxed on a sole trader or partner. On an ongoing basis, with careful planning considerable tax savings can be achieved by operating through a company. Profits can be paid to the business owner as dividends. Unlike salary, dividends do not attract national insurance contributions (NIC).

• The ability of companies to pay dividends is likely to make business incorporation an even more attractive proposition from 6 April 2003, because the rates of NIC are generally increasing from that date. For the self-employed, the rate of Class 4 NIC will be 8% instead of 7%, and profits in excess of the upper limit will be subject to an additional 1% NIC charge.

For existing companies, dividends will achieve even greater NIC savings from 6 April 2003, compared with salary payments. The employer rate of NIC increases to 12.8% from 11.8%. For employees, the rate is increased to 11% from 10%, and in addition earnings in excess of the upper earnings limit (£30,940 for 2002/03) are subject to an additional 1% charge.

• A Company’s profits can be retained and used in the business until its shares are sold or the company is wound up, thereby increasing its value. The capital gains tax regime is particularly favourable to business taxpayers where taper relief is available on the disposal of ‘business assets’, which include shares in trading companies. Taper relief can reduce the overall effective rate upon exit to only 27% for a small company and higher rate taxpayer (or only 10% if the company is within the 0% starting rate of corporation tax).

• For businesses in which goodwill is not personal to the owner, the reduction in the capital gains tax taper relief holding period for business assets to 2 years from 6 April 2002 means that (for example) a sole trader can sell substantial business goodwill to the company at an effective CGT rate of only 10%. These proceeds can be left outstanding as a loan from the individual to the company, which can later be withdrawn without further tax or NIC implications. In addition, transfers of goodwill are exempted from stamp duty, following changes announced in the last budget. Previously, the disposal of goodwill to a company (other than by a gift) could attract a stamp duty liability of between 1 and 4%.

• Trading through a limited company generally makes spreading wealth between family members much easier, by means of transferring company shares. However, care must be taken when doing so, as certain tax anti-avoidance provisions prevent individuals from effectively transferring income such as dividends to a spouse or minor children.

…and the disadvantages?

There are also some potential disadvantages to incorporation, such as the following:

• A company is an entirely separate legal entity from its business owners. The company and the individual are ‘connected persons’ for tax purposes, which means that transfers of assets between them are deemed to take place at market value for capital gains tax purposes, including gifts. Similar provisions apply for income tax purposes in respect of assets (and stock, if appropriate) when a business incorporates. Tax planning may therefore help to minimise any tax liabilities.

• Loans to company director/shareholders are not permitted under company law, subject to certain limited exceptions. Where any loans are made, tax repercussions can arise for both the company and the individual.

• A company pays tax on its profits 9 months after the end of the accounting year on profits (unless it is a ‘large’ company paying corporation tax by quarterly instalments). If the profits are extracted as a salary or bonus, any tax and NIC is payable 14 days after the tax month of payment. These payment dates can compare less favourably than those for an unincorporated business, particularly those with a 30 April year end.

• Benefits-in-kind provided by a company to its director/shareholders are liable to tax as earnings. In particular, the tax regime for company cars made available for private use can be harsh in respect of expensive cars with a large engine and high carbon dioxide emissions. The decision whether to transfer cars into the company upon incorporation therefore requires careful thought.

• Statutory compliance costs and professional fees are generally higher for companies than for unincorporated businesses. For example, companies can require a statutory audit in addition to compliance with various disclosure obligations, which can result in higher accountancy fees and other professional costs.

• Once a business incorporates, it can be difficult to revert back to sole trader or partnership status later, upon change in circumstances or tax legislation, or upon a change of heart. Tax liabilities can result.

Conclusion

In the present tax climate, it is generally considered to be potentially beneficial for sole traders or partnerships to incorporate the business, from a tax and NIC perspective. However, what will be the tax position in a year or two? In addition, taxpayers should consider all the implications of operating the business through a limited company, not just the tax ones. The commercial and legal implications need to be considered as well. As the old saying goes, “never let the tax tail wag the commercial dog”. Having said all that, if there are tax benefits to incorporation, why not take advantage of them? Careful planning will help to maximise those advantages, where appropriate.

Forbes Dawson is a Manchester based firm of tax specialists, offering tax advice to private individuals and professional firms. They can be contacted on 0161 – 245 1090 or by e-mail tax@forbesdawson.co.uk.