Starting your business as a sole trader does not mean that you cannot change into a Limited Company when the business grows and the need arises. Changing business structures can be complex when it comes to tax liabilities arising, and planning ahead can make the difference between paying taxes and saving taxes. In this article, we discuss one such strategy that can help you reduce your taxes through the use of incorporation relief.
Understanding the mechanisms of incorporation relief, aligned with HMRC guidelines, can help you mitigate taxes when switching to a limited company. We explain the specifics in detail below:
What is Incorporation Relief
If you are transferring assets from a sole trade business to a limited company in exchange for shares, you may qualify for Incorporation Relief. This relief allows you to defer some or all of the capital gains tax you would otherwise have to pay on the sale of the sole trade business to the Limited Company. You will be automatically eligible for the incorporation tax relief if you meet the following criteria:Â
- If you are a sole trader or in a business partnership
- If you transfer your business and all its assets (except cash) in return for shares in the company
It is, however, always advisable to speak to your Limited Company Accountant before putting your plan into action.
- Learn how to effectively allocate and manage shares as you transition to a limited company structure. A comprehensive guide to Shares when Starting a new Limited Company
- A Complete Understanding of Capital Gains Tax
- An Ultimate Guide For Sole Trader
Impact of Trade Debt on Incorporation Relief
Like other business liabilities, trade debts must be included in the transfer for incorporation relief to apply. Should trade debts not be included, this may complicate the transfer and maybe affect the availability of the relief. Trade debts also have an impact on the company’s valuation. The net value of the company assets less liabilities—including trade debts—will impact the shares the company issues in return. The deferred gain for CGT depends on this net value, hence it is quite important.
Solvency: One further factor could be the company’s post-transfer solvency. A company accumulating significant trade debt may have problems with solvency, which would affect its operations and the viability of incorporation.
How to Calculate Incorporation Relief
Incorporation relief under Section 162 of the Taxation on Chargeable Gains Act 1992 (TCGA 1992) states that all business assets, other than cash, must be transferred wholly or partly for shares. If the entire consideration is shares, full relief will be due but cannot exceed the value of the shares being acquired. If only part of the consideration is shares, only part of the gain will be considered for relief.
Incorporation Relief Formula
Incorporation relief = gain × (value of shares/ total consideration)
Treatment of Liabilities
The legislation is silent on liabilities, and thus, the company’s taking over of such liabilities would ordinarily be a non-share consideration. However, HMRC’s Extra Statutory Concession D32 states that HMRC is prepared not to treat the transfer of business liabilities as consideration. As this is a concession, it should be claimed, not assumed. If the company repays or refinances the liabilities, this is not the same as transferring the liabilities, which requires some form of novation and complicates the incorporation relief.
The gain being rolled over, even with full incorporation relief, cannot exceed the value of the shares. This is confirmed by HMRC in CG65765 and can be illustrated by the following example:
Example: Sole Trader Incorporating a Business
A sole trader incorporates his business, transferring goodwill of £300,000 and trade debts of £150,000. They speak to their personal tax accountant to find out what incorporation relief is available.
With ESC D32:
Gain× £150,000/£150,000 =100% of the gain is within incorporation relief.
Without ESC D32:
Gain× £150,000/£300,000 (shares and debts) =50% of the gain is within incorporation relief.
This only tells half of the story, as the gain held over cannot exceed the value of the shares, so the quantum of the gain on the disposal of the goodwill needs to be considered.Â
The value of the shares here is prima facie £150,000 (assets less debts).Â
Two Different Costs for the Goodwill:
1. Zero Cost – Gain of £300,000:
With ESC D32: Although 100% of the gain can be rolled over, the value of the shares is only £150,000, and so that is the maximum amount of incorporation relief available. The balance of the gain, £150,000, remains chargeable to capital gains tax.
Without ESC D32: Only 50% of the gain can be rolled over, i.e., £150,000. As the shares are worth £150,000, the result is exactly the same as that of ESC D32.
2. £200,000 Cost – Gain of £100,000:
With ESC D32, the entire gain of £100,000 can be rolled over into the £150,000 value of the shares, leaving the net cost of the shares as £50,000.
Without ESC D32, only 50% of the gain, £50,000, can be rolled over, leaving the net cost of the shares at £ 100,000. The remaining £50,000 of the gain is chargeable to capital gains tax.
Benefits of Incorporation from a Sole Trader to Limited Company
Incorporating a sole trader business into a limited company in the UK provides several advantages. The most significant benefit is limited liability, which protects personal assets since the company is a separate legal entity. This structure also offers tax advantages, such as profits are subject to Corporation Tax, which can be lower than personal income tax rates, and directors can pay themselves through dividends, potentially reducing their tax burden.
Incorporating a limited company can enhance its credibility, making it more attractive to customers, suppliers, and investors. This can also improve access to funding, as limited companies often find it easier to raise capital through shares or secure loans and grants.
- A Complete Understanding of Corporation Tax for Businesses, to better understand the tax implications for your incorporated entity.
- For insights on how dividend payments are taxed, delve into The Workings of Dividend Tax in the UK
- Explore Different Sources of Funding to understand the variety of financial options available for your business growth.
Incorporation Relief Property Business
Due to its substantial cost and tax benefits, many property developers, landlords, and buy-to-let property businesses are considering incorporation. If you’re contemplating transferring your property rental business to a Limited Company but remain uncertain, “Incorporation Relief” might be the incentive to help you decide on the switch.
- Guide on transferring your property rental business, see “Transferring Property to a Limited Company.“
Additional Considerations
Other issues with incorporation may include hiring purchase contracts or leasing agreements that cannot be transferred to the company without the permission of the hire purchase or leasing company. For incorporation relief, the business may include a car that, if transferred to the company, would mean a car benefit would arise to the director. Each incorporation should be considered on the facts involved, and it may well be that incorporation relief is unsuitable in certain scenarios. It is advisable to consult specialist Limited Company Accountants to carry out an efficient and smooth transfer process.
