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.

The calculation is as follows:

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 wellers.wealth@wellerslawgroup.com if you would like to know more.

This article was written by Ingrid McCleave 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.