You have been running the business successfully as a sole trader, where the earnings have got to a point when it is no longer tax efficient or you simply wish to reduce the risk of unlimited liability or present yourself as an established businessman to your customers. Forming a limited company will be attractive and rewarding in such cases.
The change from working as a sole trader to setting up a limited company, can be completed through a process called ‘Incorporation’. Incorporation is the process in which an existing business of a sole trader or a partnership firm is transferred to a company - It could be a newly formed company or an existing company or off the shelf company.
In this article we cover:
- Lower Rate of Tax - Companies pay corporation tax (CT) on their profits, the rates for which are lower (19%) as compared to individual taxes rates of 20%/40% or even 45%.
- Control: You only need to pay tax when you extract profits from the company compared to a sole trader or partnership firm, where you are taxed on all the profits made by the business whether or not you actually draw the profits from the business.
- Optimisation of Allowances - Better utilisation of allowance as you have full control over how and when you are taxed on the income you withdraw from the business.
- National Insurance Contributions (NIC) Savings - As a sole trader, you pay Class 4 NIC on your profits at 9% but from the company perspective, if you withdraw the profits as dividends, you don’t need to pay NIC on dividends
- Limited liability – As a sole trader or a partner in a firm, you have unlimited liability and can become bankrupt. Your liability is limited as a shareholder when your company has a separate status.
- Tax Planning Opportunity – You can gift company shares to your spouse or partner in order to take advantage of tax allowances available and optimise your take home in an efficient way.
- Professional - It may give your business a more of a professional edge by showing the world that you're a legitimate setup. Generally, limited companies are perceived to be established compared to a sole trader or a partnership firm.
- Protection - You can protect your business name by registering it
- Expense Claim - You can claim more tax reliefs on expenses that you couldn’t claim as a sole trader.
- Succession: Passing business to family members is easier with company because you can give away shares and pass the business to them over a number of years.
Why not to Incorporate?
If your earnings are relatively low, you’ll likely want to retain your tax affair and accounting as simple as straight so that it could simply be managed by you or you would pay least accountant fees that tend to come with being incorporated because of the additional responsibilities and compliance.
One thing to consider about here is whether you are giving preference to the limited liability aspect or you can afford personal involvement.
If your earning is going to increase, you may go for incorporating a limited company. Certain things which you need to take into account while making this decision includes how much profit you’re making and the current rates of tax you’ll need to pay.
The costs pertained with being a limited company rather than a sole trader would be lower than your profit to make it worth your while, so it would be good to do some calculations before you proceed for the next step.
It’s also worth keeping in mind about the time and effort involved in bookkeeping and other administrative tasks and compliance work around being incorporated. though, if you want to borrow money/ investors to grow your business, this would be far easier if you make the change from sole trader to limited company status.
Major steps you should consider if you're changing from sole trader to limited company:
- Decide whether you'll be the sole director or whether you want to bring in others
- Inform HMRC about your legal structure as it’s changed – this is very important because changing legal structure would affect the tax bill you are going to pay.
- Choose a name for your limited company, if you don’t have a name for your business.
- Register your business with Companies House – to do this you'll need to setup your memorandum and articles of association and likewise, within 3 months of starting of trading through the company, you must register for Corporation Tax.
- Set up a new business bank account for your limited company
- Tell your insurer that your legal structure has been changed.
- Inform all of your existing customers, suppliers, lenders, service providers and employees about the changes in the structure
- If your sole trader business is already registered for VAT, you will have to cancel your VAT registration within 30 days of the change and then re-register through the company.
- To be able to pay yourself a director’s salary, you must first register your company for PAYE as an employer. If you already employed people, you should speak to HMRC about the change in business structure.
- In case of property involvement - if there is a mortgage, lenders approval would be needed else refinance or create a new agreement and value the property at the date of incorporation by a surveyor.
Changeover procedure towards Incorporation
- A new company would be setup
- You could be the sole director and shareholder or else you can bring other as well.
- All business assets or some assets will be transferred to the company at the Market Value (In case of property business whole must be transferred)
- Consideration for assets could be shares or cash or a loan account or by way of gift or any other type of combination.
Changing from a Sole trader to the company could be complex, if the series of steps are not followed in sequence and carefully. It involves various tax implications which make this straight forward process a bit tricky.
A few implications are as follows which you need to take care of
- Income tax effects of incorporation: Your sole trader business or partnership ceases to trade, so you will be preparing your tax returns based on closing year rules and consider overlap profits (if any).
- Capital Allowances: If any asset is purchased in the last accounting period, no annual investment allowance, first year allowances or writing down allowances are available.
- Capital Gains Tax (CGT) on the transfer of assets: The business assets like land and building, goodwill etc. transferred to limited company will be considered disposal at market value because you are connected to the company. This may result in a chargeable gain, which could be subject to CGT. CGT payable could be reduced to NIL or minimal amount, if s.162 incorporation relief is available.
- VAT: If the business is VAT registered, you may need to charge VAT on the transfer of assets to the company on incorporation. However, if the business is transferred as a going concern (TOGC), it will be outside the scope of VAT.
- Stamp duty land tax (SDLT): If land and buildings are transferred, SDLT may become payable even if there is no consideration as the transfer is between connected parties which needs to be considered.
- Corporation Tax: Corporation tax issues for the newly created company
- Other Issues: Change in status for NIC purposes, Inheritance tax, Legal and compliance issues on incorporation and ways of extracting funds from the new company – salary, dividends, pensions, benefits like company car etc.
What reliefs are available on incorporation?
There are some generous reliefs available from HMRC where you can defer or reduce your tax bill when incorporating your business.
Incorporation Relief (s.162 relief)
In this option, incorporation relief delays paying capital gains tax (CGT), if you transfer your sole trader business to a limited company in return for shares rather than cash
Incorporation relief broadly means that any CGT charge on the whole, or part, of the gains, is postponed until the person transferring the business disposes of the shares. In other words, until you will leave the limited company by disposing of shares. To qualify for incorporation relief, the following 3 tests need to be satisfied:
- The business must be transferred as a going concern.
- All assets of the business (except cash) must be transferred to the company.
- The consideration paid to you by the company, must be wholly or partly in shares.
HMRC no longer provides clearance for s.162 Incorporation relief, so you need to establish all the facts before it is ascertained whether the relief applies or not. In certain cases, it may not be beneficial to claim the relief and you will need to make an election by writing to HMRC.
Gift or Holdover Relief (s.165 relief)
If you would not transfer all your assets to the company, instead decide to gift a few assets only, gains on individual business assets may be held over in full or in part, and you can also receive partial cash consideration from the company. This may be particularly useful when you wish to retain certain assets personally rather than transferring it to the company.
This is a more flexible relief than s.162 and means that you may be able to use up your CGT annual exempt amount. Property rental business may not qualify for this relief.
Business Asset Disposal Relief (BADR)
BADR formerly known as Entrepreneur's Relief, reduces the CGT payable on the disposal of business assets to a new company. The relief reduces the CGT rate to 10% and is allowed on cumulative gains up to a lifetime allowance of £1 million. Property rental business may not qualify for this relief.
Incorporation of business can become complicated especially, when there are assets involved, so you need to consider various factors before deciding if this is a right approach for you. DNS, specialises in incorporation and has vast experience in supporting new and existing limited companies. By plugging into our expertise, you can more focus on the growth and development of your business and we can advise you on this aspect as well.
To find out more about incorporation of business, or any other tax issues, get in touch and speak with one of our experts.
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