Author: Wellers

You currently run your business as a sole trader or partnership and want to know the advantages and disadvantages of incorporating that business.

One of the advantages is that a company has limited liability whereas as a sole trader or partnership you have unlimited liability.

As an individual, your trading profits may be taxed at 45%, whilst a company pays tax at 19% for 2019/20 and 2020/21.

A disadvantage is that you will no longer be able to set your trading losses in the future against other income, once you have incorporated.

You also need to consider what your stamp duty land tax bill will be on transfer of land and buildings to the company.  If it is too great, you may instead wish to consider Gift Relief as an alternative.

This article explores the Capital Gains Tax implications when a sole trader transfers his business to a limited company by transferring the business assets to the company, through which he continues to trade. 

The sole trader and the company are connected persons and therefore there is a deemed disposal by the individual to the company at market value.

Usually the only Chargeable Assets are land, buildings and goodwill.  Plant and machinery, other than exceptionally, suffer losses, which are dealt with under the Capital Allowances regime.

If any buildings transferred have benefited from structures and buildings allowance (where they have been used for business purposes such as offices, retail premises, factories and warehouses), having met the conditions of the allowance, the consideration for the disposal is increased by the total amount of allowance already claimed when calculating the gain for Capital Gains Tax purposes.

The object of Incorporation Relief is the deferral, wholly or partly, of gains on chargeable assets. 

The deferred gain is rolled over and set against the base cost of the sole trader’s shares in the company. The gain will be charged when the shareholder sells his shares in the company.

Usually the value of the shares received is the same as the total consideration received by the individual from the new company and the Incorporation Relief fraction will be one.  In these circumstances, the whole of the gain is deferred and no gain is chargeable.

If the company pays for the business with loan stock i.e. something other than shares, a Chargeable Gain will arise.

The mechanics of this is usually achieved by the company opening a Directors’ Loan Account. The sole trader who then becomes a director can then withdraw money from the loan accounts once the company is profitable.

To qualify for Incorporation Relief the following conditions must be met:

• The business must be a going concern.
• All assets of the sole trader’s business must be transferred, with the exception of cash, to the company.  If the sole trader wishes to retain land and buildings outside of the company e.g. to save Stamp Duty Land Tax, he will not be eligible for the relief.
• The consideration received by the sole trader must be wholly or partly in shares.

The relief applies automatically when the above conditions are met.

In order not to waste the sole trader’s Capital Gains Tax annual exempt amount, it is possible to calculate the amount of Directors’ Loan required to generate a gain equal to it.

If the sole trader decides to utilise Entrepreneurs’ Relief, he can organise his consideration so that a Chargeable Gain above the annual exempt amount is triggered and he can take advantage of the relief at this stage. He may wish to do this if the shares in the company on sale would not qualify for Entrepreneurs’ Relief.

Entrepreneurs’ Relief is available on any Chargeable Gains on the transfer of land and buildings but not goodwill where the sole trader receives 5% or more of the shares in the company.  The rationale behind this is that if the sole trader is retaining less than 5% of the shares then he is truly selling the business and reducing his involvement in it and therefore in those circumstances Entrepreneurs’ Relief would be available on the gains attributable to the transfer of goodwill.

Provided, the company is the shareholder’s personal trading company and the shareholder works for the company and meets the other criteria for Entrepreneur’s Relief, you can look through the incorporation and include the period during which the business was owned by the sole trader, when considering the two-year qualification period for Entrepreneurs’ Relief, prior to the sale of the shares. Entrepreneurs’ Relief will be available provided shares were issued wholly or partly in exchange for the transfer of the business as a going concern.  Provided the business and the shares in the personal company have been owned for a combined period of 2 years and the individual shareholder works for the company. A subsequent sale of the shares would qualify for Entrepreneurs’ Relief.

Dis-applying Incorporation Relief

The sole trader can elect to dis-apply Incorporation Relief if they want to use full Entrepreneurs’ Relief or have Capital Losses to use.  This may be the preferred route where the shareholder no longer works for the company at the date of the subsequent sale of the shares and so Entrepreneur’s relief would not be available at that stage.

Gift relief

To avoid paying Stamp Duty Land Tax on the transfer of the building to the company at market value, the sole trader can alternatively gift the assets to the company.  The deferred gain is rolled over and reduces the base cost of the assets in the hands of the company. The deferred gain does not reduce the base cost of the shares.

If you do not transfer all of the business assets except cash to the company, Incorporation Relief is not available.

This is a complex area and the advice of your accountant or tax advisor should be obtained in advance of any transaction.  We are very happy to advise you either separately or in conjunction with your accountant or legal advisor.

Wellers Wealth are very happy to work in conjunction with your independent financial advisor, accountant or legal advisor on such matters.

Please call us on 020 7481 2422 or email us at enquiries@wellerslawgroup.com if you would like to know more.

This article was written by Wellers Law Group LLP and the law is correct as at 24th November 2020. Please note that tax legislation changes frequently, so this article should not be relied upon without seeking further legal advice.

How to use Entrepreneur’s Relief? 

The budget 2020 announcements reduced the lifetime limit for gains qualifying for Entrepreneurs’ Relief from £10 million to £1 million for qualifying disposals made on or after 1 March 2020. So how should you make use of this important tax benefit?

The Government’s rationale for this reduction is the relief has done very little to generate additional entrepreneurial activity, primarily benefitting a small number of very affluent tax payers.

John Cullinane, the Tax Policy Director of the Chartered Institute of Taxation is calling for MPs to look closely at the Government’s plans for Entrepreneurs’ Relief and in particular why the review was not carried out in public.  He goes on to say “there are people affected by the March 2020 budget change who have reinvested money in the expectation of the relief that they will no longer receive”.

Under the budget 2020 proposals, Entrepreneurs’ Relief is to be re-badged “Business Asset Disposal Relief”.

Entrepreneurs’ Relief is a Capital Gains Tax Relief available to taxpayers who sell or give away their businesses. 

The relief operates by reducing the Capital Gains Tax payable on the gain (or deemed gain in the case of a gift) to 10%.  This is regardless of whether the taxpayer is a basic, higher or additional rate taxpayer. 

Up until the budget 2020 there was a lifetime limit of the gains qualifying for Entrepreneurs’ Relief of £10 million, but this has now been reduced £1 million. 

The relief is available to sole traders or partners selling or gifting the whole or part of their business, company directors and employees who dispose of shares or securities in a personal trading company that they work for and directors and employees who acquired shares under the EMI Option Scheme.

To qualify there must have been material disposals of business assets. 

A business asset is defined as:

• The whole or part of a sole trader or partnership business.
• A disposal of an asset used in a business at the time the business ceases to be carried on.
• A disposal of shares (securities, loan stock etc.) in a company.
• A material disposal means that the business must have been owned by the taxpayer for at least two years prior to the disposal.
• A disposal of furnished holiday lettings qualifies for Entrepreneurs’ Relief, provided the other conditions are satisfied.  A residential property business would not qualify.

In respect of assets used in the business at the time the business ceases, the asset must be sold within 3 years of the cessation of trade. 

Shares in a personal company

The conditions are that the individual owns at least 5% of the ordinary share capital and at least 5% of the voting rights which is exercisable by the individual by virtue of that holding. 

The second condition is that the taxpayer must work for the company or for another company in the same group.  This would include full-time or part-time employees or directors.  There is no minimum number of hours of work required.

In addition, the shareholder must either be entitled to at least 5% of the distributable profits and 5% of the assets available on the winding up and/or be entitled to at least 5% of the proceeds of disposal of the whole of the ordinary share capital of the company.

Associated disposals are also eligible for Entrepreneurs’ Relief:

The associated disposal rules do not apply to sole traders.

To qualify as an associated disposal a number of elements must be satisfied. You must have made a material disposal of the business or shares and securities in a company. As part of the withdrawal from the business you make a disposal of an asset which has been used in that business for at least 2 years and was acquired on or after 13 June 2016. The asset must have been owned by you for 3 years prior to disposal. 

An example: a company director owns at least 5% of the shares of a company and also owns the premises from which the company trades. Provided he sells the building at the same time as he sells the shares, this could be an associated disposal provided the other criteria apply.

Entrepreneurs’ Relief can be claimed on part-disposals of businesses or business assets provided the disposal represents at least 5% of the shareholding (see above) or 5% of partnership assets. Provided the taxpayer has owned 5% or more for three of the eight years prior to the disposal, a material disposal may be of less than a 5% interest provided it is of the whole of the individual’s partnership assets/shareholding. 

The associated disposal must take place within one year of the business cessation or within three years, so long as the assets have not been leased or used for any other purpose.  If the individual taxpayer has charged the business rent for use of the assets, at its full market rent, no Entrepreneurs’ Relief is available.  If less than the market rate rent has been charged for the business, some Entrepreneurs’ Relief will be available.  If no rent is charged, then full relief is available.

Interaction with Rollover Relief

If you make a material disposal of business assets and you re-invest in a new business, you may look at first to see if there is any Rollover Relief available for the investment in the new business and apply Entrepreneurs’ Relief to any gains remaining after the Rollover Relief has been claimed. 

Interaction within Incorporation Relief

If you transfer your business to a limited company you may wish to consider whether Entrepreneurs’ Relief would be available to you on any gains arising on the incorporation.

The main point to note is, that Entrepreneurs’ Relief will not be available in respect of any gain arising on the transfer of goodwill to the company. Under Section 169LA TCGA 1992 where goodwill is disposed of to a close company and the transfer is of 5% or more of the share capital of the company (or the shareholder exercises at least 5% of the voting rights or the shareholder is a beneficiary entitled to at least 5% of the profits available for distribution and at least 5% of the assets on a winding up or would be beneficially entitled to at least 5% of the proceeds on the disposal of the whole company) then goodwill is no longer a relevant business asset for the purposes of Entrepreneurs’ Relief.

In those circumstances, Entrepreneurs’ Relief would not be available for the value of the goodwill but Entrepreneurs’ Relief would be available where the transferor holds less than 5% of the shares of the company and does not meet any of the other tests listed above.  The rationale behind this is that the individual is genuinely selling their business and reducing their involvement in it.

In summary, Entrepreneurs’ Relief is one of the most attractive benefits available to entrepreneurs.  You can claim as many times as you like provided your claims are within the £1 million lifetime limit.  It is available to individuals, not companies.

If you are selling a business, you have to be the sole trader or a business partner for the two year qualifying period. 

If you are selling shares you have to have been an employee or officer in the company as well as owning the shares for the qualifying period.  The company itself must be a trading company or the holding company of a trading group and must have traded within the qualifying period.

There is one case in which you are not required to be working in the business under an extension called Investors’ Relief.

The pitfalls of not dotting your ‘i’s’ and crossing your ‘t’s’

A £1 million tax relief can be lost on a technicality.  It is therefore essential that you seek advice within at least two years prior to your retirement and earlier if possible. This is to ensure that you are eligible for the relief and if you are not eligible, to give us time to see what can be done to ensure you become eligible.  Do not wait until after you have sold your business interests or your shares before checking. 

The sorts of things that you will need to consider are whether you have any evidence that you have worked as an employee or officer for the company because if you can’t prove it you won’t be eligible.  It would be sensible to have a written Employment Contract for example.

There is no set definition of trading given by HMRC.  A company’s trading status is evaluated based on several factors.  Trading can in certain circumstances extend to a one-off transaction resulting in unexpected profits.

Lots of businesses have a mixture of trading and non-trading activities.  Companies with mixed business trading can still be eligible for Entrepreneurs’ Relief provided the non-trading activities are not substantial.  HMRC considers substantial to be anything over 20%.  So for example provided rental income received by the company equates to less than 20% of the company’s total trade and the staff are not spending more than 20% of their time in relation to non-trading activities, then you still may be able to qualify. 

If your company is cash rich you could risk failing the trading status test unless such cash has been earmarked for a trading purpose.

Assets used in the business up to Cessation of Trade and subsequently sold

The business must be owned for at least two years prior to cessation and the asset must be sold within three years of the cessation. In these circumstances, the asset would qualify for Entrepreneurs’ Relief. 

EMI shares

There are additional requirements to comply with if the shares are from an EMI.  To be eligible for Entrepreneurs’ Relief you must have:

• Purchased the shares after 5 April 2013.
• Be offered the option to buy them at least two years before selling them.

The requirement to hold 5% or more of the voting share does not apply when it comes to disposing of EMI shares.

One way round the lower limit (the £1 million lifetime limit) would be to consider gifting shares to your spouse, since these are transferred at no gain no loss. Provided your spouse met the criteria, they would also have a full Entrepreneurs’ Relief lifetime limit.  This doubles your tax relief. 

If you are dissolving your company, Entrepreneurs’ Relief can still be claimed provided:

• The distribution of company assets is taxed as a capital distribution, not as income.
• Distribution takes place within three years of the date of cessation of trade.
• In the two years prior to the company ceasing to trade, the usual qualifying conditions were met.  

You will need to discuss this with your accountant but you may find paying the 10% Capital Gains Tax suits you better than seeking out your profits over several years with a traditional small salary of £12,000 or so per year plus dividends on which only 7.5% tax is payable.

There is anti-avoidance legislation that was introduced in April 2016 which prevents individuals from closing companies simply as a way of taking advantage of the tax efficiency of the capital distribution route rather than an income distribution.

Distributions from the voluntary liquidations of a company may be treated as income distributions in the following circumstances:

• If the company is a closed company (a company with five shareholders or less).
• If the shareholder receiving the distribution is involved with a similar trade or activity within two years.
• If the intention of winding up the business appears to be to obtain a tax advantage.

In these instances, the distributions could be subject to income tax and ineligible for Entrepreneurs’ Relief.

The legislation surrounding Entrepreneurs’ Relief is complex and professional advice should be sought well in advance of retirement, incorporation or gifting of business assets.

Wellers are very happy to work in conjunction with your independent financial advisor, accountant or legal advisor on such matters. 

Please call us on 020 7481 2422 or email us at enquiries@wellerslawgroup.com if you would like to know more.

This article was written by Wellers Law Group LLP and the law is correct as at 24th November 2020. Please note that tax legislation changes frequently, so this article should not be relied upon without seeking further legal advice.