Transferring your sole trader or partnership business to a company can reduce tax on profits but may result in an initial capital gains tax bill. You can defer this indefinitely but might there be advantages to paying it?
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 June 2024. Two years later he transfers all its assets to a company and received shares in exchange. The only asset the business had which was to 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 of £3,000, and assuming Andreas is a higher rate taxpayer, the CGT payable on the gain is £19,400 ((£100,000 – £3,000) 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 £3,000 available. His CGT bill is therefore £3,400 ((£20,000 – £3,000) x 20%). When he sells 20 months later the gain will be £80,000 and the CGT £15,400 ((£80,000 – £3,000) x 20%). Andreas’s total CGT bill for the two transactions is £18,800. By disapplying incorporation relief Andreas has saved a modest £600 in CGT. The saving is achieved because by splitting the gain in two he was able to use two annual CGT exemptions. This is a marginal advantage that won’t increase regardless of the size of the gain he makes.
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 2022/23, an election must be made by 31 January 2026.
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.
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.