When and how should you incorporate a business?
I have often heard sole traders say that it will cost too much to become a limited company. This is because many sole traders prepare their own accounts and do their own self assessment returns and are unaware that the cost involved in becoming a limited company really aren’t that high.
What is a Limited Company?
A limited company is an organisation that you can set up to run your business – it’s responsible in its own right for everything it does and its finances are separate to your personal finances.
Any profit it makes is owned by the company, after it pays Corporation Tax. The company can then share its profits.
What is a Sole Trader?
If you start working for yourself, you’re classed as a self-employed sole trader – even if you’ve not yet told HM Revenue and Customs (HMRC).
As a sole trader, you run your own business as an individual. You can keep all your business’s profits after you’ve paid tax on them.
You can employ staff. ‘Sole trader’ means you’re responsible for the business, not that you have to work alone.
You’re personally responsible for any losses your business makes.
The key Advantages and Disadvantages of Companies are shown below.
The Incorporation Spreadsheet created by Practice Track is an Excel spreadsheet which shows the tax savings that are available to sole traders and partnerships if they chose to incorporate. It can also be used for incorporated clients to compute the taxes payable under the new dividend regime.
It is therefore a useful tool to use for planning purposes for clients who are already incorporated and can reinforce the point to many clients that they are still saving tax by being incorporated.
It also caters for salary and dividend profit distribution between multiple director-shareholders (up to six).
The detailed output sheets are not password protected so you can insert extra calculations or override the formulae if you wish.
How do you form a Limited Company?
You can form your company directly with Companies House for £15, it normally takes 24 hours
- the company’s name and registered address
- names and addresses of directors (and company secretary if you have one)
- details of shareholders and share capital
Personally, I find it easier to use a formation agent such as Company Wizard for £16.99
Often using an agent will mean the company is formed quickly, sometime within a couple of hours.
There are three different ways in which the sole trader can be incorporated. It’s highly likely that Incorporation Relief will be the best way to incorporate in most cases, however, it is worth considering all the options when advising clients.
Incorporation Tax will apply automatically unless the transferor elects for it not to in writing.
To benefit from Incorporation Relief the business will need to be valued at open market value including Goodwill prior to transfer to the limited company
There are 3 conditions which must be satisfied before incorporation relief can be claimed:
- The business transferred must be a going concern;
- All assets owned by the business (except cash) must be transferred to the limited company.
- The consideration paid for the business assets must be wholly or partly in shares.
Example You transfer your business in return for shares worth £100,000. You make a profit of £60,000. You later sell the shares and need to work out the gain – their cost for your Capital Gains Tax calculations is £40,000 (£100,000 – £60,000).
Example Your business is valued at £100,000 when you transfer it, and you receive 80% in shares (£80,000) and 20% in cash (£20,000). You made a gain of £50,000. You can postpone 80% of the gain (£40,000) until you sell the shares. You need to pay Capital Gains Tax on 20% of the gain (£10,000) in your next tax return.
The official helpsheet with further advice is HS276.
Holdover relief applies when business assets are transferred from an individual and avoids capital gains on the chargeable assets becoming immediately liable to capital gains tax.
You sell a shop worth £81,000 to your brother for £40,000. It cost you £23,000. Include the £17,000 gain (£40,000 minus £23,000) when you’re working out your total taxable gain.
This method is useful if you want to keep a property outside of the company and prefer instead for the company to pay a rent for the property. This will have certain tax advantages but it is important to note that this can mean that the owner will lose entitlement to entrepreneurs’ relief on the property, because the property would then be regarded as an investment property.
Selling your Sole Trader Business to your Limited Company
Until December 2014, this was often the preferred option because Entrepreneurs Relief could be applied to gains and in many cases the company could write down the Goodwill against Corporation Tax.
However, this option could still be worth considering.
Let’s take a typical scenario:
- Mr Smith has been running a small garage for a few years
- he decides to incorporate his business and sets up Smiths Garage Limited with himself as the sole director and shareholder
- he transfers the goodwill of the business and its other assets and liabilities to Smiths Garage Limited but does not claim incorporation tax relief under Taxation of Chargeable Gains Act (TCGA) 1992, s162, nor does he claim hold-over relief under TCGA s162
- at the time of incorporation, the goodwill of the business is valued at £11,100
- Mr Smith makes a chargeable gain on the transfer of the goodwill, which is deemed to be at market value, of £11,100 which, after deducting the annual CGT exemption (£11,100 2015-16) the company will pay
- the acquisition of goodwill is done by way of a credit to Mr Smiths director’s loan account. Mr Smith is able to draw down on this account without any further tax charges.
These considerations all show that incorporating a sole trader business is not only straightforward but can also greatly benefit the sole trader client both financially and in the potential flexibility it can provide for their business.