It doesn’t matter whether you have a partnership, an LLP or just have properties in your own name, provided you play an active role in managing your properties you could qualify for Section 162 Incorporation Tax Relief which will allow you to roll/hold over the capital gain into shares in your new company.
If you, either as an individual or in partnership, incorporate a business by transferring the business, together with all the assets of the business, in exchange wholly or partly for shares, you can defer some or all of the gain arising from the disposal of the ‘old assets’ (the business and the assets of the business) until such time as you dispose of the ‘new assets’ (the shares).
This relief is given automatically by Section 162 Taxation of Chargeable Gains Act 1992 provided the various requirements are met.
The key problem area is that Property Investment is generally not considered to be a Trade but because of the uncertainty created by recent legal cases you are able to ask HMRC for a Non-Statutory Clearance. This is effectively written approval from HMRC.
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.
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.
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.
These are:
Incorporation Relief
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
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.
Example
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.
In Summary
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.
There are many reasons why residential property investors are now rushing to incorporate, the biggest reason being the Restriction of Mortgage Interest Tax Relief.
Clause 24 of the Finance Bill sets out plans is to restrict individuals on claiming mortgage interest as a cost against their property investment income, for individuals it will work as follows
2017/18 75% of the interest can be claimed in full and 25% will get relief at 20%
2018/19 50% of the interest can be claimed in full and 50% will get relief at 20%
2019/20 25% of the interest can be claimed in full and 75% will get relief at 20%
2020/21 100% will get only 20% relief
For a 20% tax payer that’s fine but for higher rate taxpayer its a disaster that will lead to them paying a lot more tax
These rules will not apply to Companies, Companies will continue to claim full relief.
When you sell or give a residential property to your Company you will incur Capital Gains Tax if you make a gain, its for this reason many investors and their advisers believe that they are ‘automatically’ entitled to claim Incorporation Tax Relief, but in many cases Incorporation Tax Relief will NOT be available!
In summary Incorporation Tax Relief allows Sole Traders to postpone/hold over a gain by transferring all their business assets into a limited company in return for Shares.
The key problem area is the Property Investment is generally not considered to be a Trade.
Mrs Ramsey arranged and attended to maintenance issues (drains)
Mrs Ramsey and her son maintained the garages and cleared rubbish
Mrs Ramsey dealt with post
Mrs Ramsey dealt with fire regulation issues
Mrs Ramsey arranged for a fence to be erected
Mrs Ramsey created a flower bed
Shrubs were pruned and leaves swept
The parking area was cleared of weeds
The flag stones were bleached
Communal areas were vacuumed
Security checks were carried out
She took rubbish to tip
She cleaned vacant flats
she helped elderly tenants with utilities
This work equated to at least 20 hours per week and Mrs Ramsey had no other employment.
It is because she did the work herself that her property investment was considered a ‘Business’ and eligible for Incorporation Tax Relief. In summing up the Judge said…
If Mrs Ramsay had employed a Property Management Company or Letting Agent to do the work she would NOT have been able to claim ‘Incorporation Tax Relief’.
Most Buy to Let Landlords with one or two properties are Passive Investors who delegate all the responsibilities to professional letting agents, they will not be doing enough to comprise a business!
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 £100,000
Mr Smith makes a chargeable gain on the transfer of the goodwill, which is deemed to be at market value, of £100,000 which, after deducting the annual CGT exemption (£10,900 2013-14), will be taxable at 10% due to the availability of entrepreneur’s relief(note rules changed 3rd December 2014 and ER is no longer available normal rates of CGT now apply)
the company will pay Mr Smith £100,000 for the acquisition of goodwill and this 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.
In addition Mr Smith started his Sole Trader business after the 1st April 2002 so he can claim a corporation tax deduction for amortisation of the goodwill in the company accounts. Small Companies pay Corporation Tax at 20%, so being able to deduct Goodwill on £100,000 will save £20,000 in Corporation Tax. (note rules changed 3rd December 2014 and Section 849C CTA2009 prevents this on related party goodwill)
Where a trader transfers his business to a limited company of which he is a ‘substantial shareholder’, the parties are treated as ‘related parties’ and the transfer must be at market value, but you can ask HMRC to carryout a post transaction valuation check by submitting form CG34
Goodwill relating to personal services is not normally considered to have a market value as it can not be transferred
In general it is expected that intangibles will have a useful life of no more than 20 years (note new rules – FRS102 states
“If an entity is unable to make a reliable estimate of the useful life of goodwill, the life shall not exceed five years.”)
Get professional advice to help you to prepare the valuation, disclose the capital gain and claim the tax relief
