Incorporate Or Die?

RICHARD HOLME and ELIZABETH ROBERTSON of Creaseys ask if the death knell has been sounded for the unincorporated business.

GORDON BROWN'S 17 April Budget statement contained many incentives for businesses to incorporate, for instance, no tax where profits are £10,000 or less, a small companies rate of just 19 per cent together with the ability to take National Insurance-free dividends as a means of remuneration. Moreover the sole trader or partner could sell his business to his own limited company and pay capital gains tax at the new ten per cent business asset rate. The resulting proceeds left on loan account can then be used to draw down profits in a tax effective manner... or are things that simple?

Contemplating change

Let us take Eric and Fred as they relish this intoxicating prospect on the 19th hole. Both are sole traders earning profits of around £100,000 a year. Eric has had a mailing from his accountant who says he is advising virtually all his sole traders to incorporate for tax reasons. Although Eric can see that this will complicate the preparation of his accounts (and increase his accountant's fees), he is tantalised by the 19 per cent tax his company will pay. Currently he pays tax at 40 per cent on most of his profits. He plans to incorporate at his next year end, 31 March 2003, as he switched to that accounting date when self assessment was introduced. His accountant has said that he can sell the goodwill of his business for market value of £51,000 to Eric Ltd and will have to pay just ten per cent capital gains tax on this. Although this means he has about £5,000 of capital gains tax to pay, he understands that the loan account arising from the sale gives him a means of drawing profits out of the company in a tax effective manner. This is better than, say, dividends on which an effective tax rate of 25 per cent is charged.

Eric is already contemplating how he can spend this extra income resulting from the '13 per cent tax cut' (see Example below) he has achieved, notwithstanding Gordon Brown's attempt to take another one per cent from him. The savings will be nowhere near as great in future years unless, however, Eric risks his wife owning some shares.

On the other hand

Fred has heard nothing from his accountant, although in the past when he has asked about incorporation, he remembers being told that a company means more red tape and his employees will see how much he earns. Also he recalls advice that if he sold his business there may be extra tax to pay if he does so soon after incorporating.

Finally, Fred summons up the courage to visit his accountant, Bob, who agrees that following the Budget there are some advantages in incorporating. He reminds Fred, though, that he has had a 30 April year-end to defer tax on his rising profits. As a result, if he follows his friend Eric and incorporates on 31 March 2003, his tax bill for 2002-03 could almost double due to the assessment being based on the 23 months to 31 March 2003 less a low level of overlap relief related to the low profits he was earning in 1996-97.

Although Fred tries to accept that this is merely an acceleration of tax he would otherwise have paid on retirement, he wonders how he will be able to fund this hit to his cash flow. Bob reminds him that he could make some payments into his personal pension fund but, due to the changes at April 2000, he can only use current year (albeit very high) assessable earnings as a benchmark.

Fred also mentions that an offer may come in for the business and he is keen to pay as little tax as possible on any gain made. Bob explains that the taper clock will stop on incorporation and thus another two years must elapse before Fred will achieve a ten per cent rate on selling the shares. Fred thinks he has seen something in the Budget statement about help in this area and Bob on reading the small print, sees that Fred could pay tax on incorporating his business at ten per cent, thus reducing the tax subsequently payable on a sale of shares. All of this, though, will add to Fred's tax bill for 2002-03 to make it his biggest ever.

Final decision

Fred sees that perhaps after all he should stay as a sole trader, and bring his wife into partnership with him so as to reduce tax on profits. They can together catch up with their pension contributions and thus reduce the tax payable by the business, short term at least.

All in all, Fred and Eric drink up and realise there are no definite answers in this business, although the opportunities for incorporation remain exciting with the right advice … so long as dividends remain National Insurance free.

(All figures in the article assume personal allowances and capital gains tax exemptions are equal to any other income and gains.)

Richard Holme and Elizabeth Robertson can be contacted by e-mail: taxadvice@creaseys.co.uk, or visit www.creaseystaxconsulting.co.uk.

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