If you transfer your sole trader or partnership business to a company, incorporation relief prevents a capital gains tax (CGT) bill being triggered. This sounds like good news but might you be better paying the tax instead?
Business incorporation
If you transfer your unincorporated business to a company it’s treated for tax purposes as if you sold it. If the business assets are worth more than they cost you, you will have made a capital gain. However, if you receive shares in the company in exchange for your business assets, and other conditions are met, the capital gain isn’t taxed but is rolled forward until you sell or transfer your shares in the company. This is known as incorporation relief .
What’s the gain?
The deferred capital gain is the difference in value between what the business assets cost you and what they would fetch if you sold them to a third party rather than transferring them to a company. Incorporation relief seems generous but it might not be advantageous.
Example – with incorporation relief. Andreas started as a sole trader in March 2018. Two years later he transferred all its assets to a company and received shares in exchange. The only asset the business had which was liable capital gains tax (CGT) was its goodwill, worth £20,000. As Andreas paid nothing for it the incorporation results in a capital gain of £20,000. Incorporation relief applies and so taxation of the gain was deferred. 20 months later Andreas accepts an offer of £100,000 for his shares. His taxable gain is the whole £100,000; in effect, he gets no deduction for the value of goodwill which he gave to the company when he incorporated his business. After knocking off his annual exemption, say £12,300, and assuming Andreas is a higher rate taxpayer, the CGT payable on the gain is £17,540 ((£100,000 – £12,300) x 20%).
Example – without incorporation relief. If Andreas elects to disapply incorporation relief the gain of £20,000 would be taxable for the year in which he incorporated his business. Andreas has his full CGT annual exemption of £12,300 available for that year. His CGT bill is £1,540 ((£20,000 – £12,300) x 20%). When he sells 20 months later the gain will be £80,000 and the CGT £13,540 ((£80,000 – £12,300) x 20%). Andreas’s total CGT bill for the two transactions is £15,080. By disapplying incorporation relief Andreas has saved CGT of £2,460. The saving is achieved because by splitting the gain in two he was able to use two annual CGT exemptions.
Make the election
The election to disapply incorporation relief must reach HMRC within two years following the normal filing date for the tax return covering the year in which incorporation occurred. For example, if a business is incorporated in 2020/21 an election must be made by 31 January 2024.
Trap. The election deadline is shortened by a year if you sell or transfer your shares in the year following that in which your business was incorporated.
Tip. Common situations where an election might save you tax are: where the gain is less or not much more than your annual CGT exemption; you have capital losses that reduce the gain; or the gain qualifies for business asset relief but might not after it has been deferred.
You can elect for incorporation relief not to apply. This can save you tax in the long run by, for example, doubling up on the annual CGT exemption, making use of business asset disposal relief that would otherwise be lost and making use of capital losses. Be aware of the time limit for making the election, which can vary.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.