Sole Trader & Partnership Incorporations

Transferring a business into a company can offer significant tax benefits.

Sole Trader & Partnership Incorporations

There can be significant tax (and other) benefits when a business converts from a sole tradership or partnership into a company. A question that is frequently posed is how can that transition be achieved without immediate tax cost?

An example of planning we have implemented for a client:

Scenario

A couple (husband and wife) owned a residential property portfolio consisting of 12 properties and worth around £2.7 million. There was still a loan of around £500,000 in total charged against 4 of the properties. The portfolio was standing at an aggregate gain of around £1.4 million at the time of the proposed transaction. The couple wanted to reconsider the business structure following the changes that were made to the tax-deductibility of loan interest.

After reviewing the situation, it was decided to transfer the business into a company in consideration for the issue of new shares (i.e. to incorporate the business).

The tax planning opportunity

Where the circumstances allow an incorporation to take place, the tax benefits can be very significant. Profit on rental income is taxed only at Corporation Tax (CT) rates of 19%. This can compare favourably with personal tax rates and provides at least a deferral of tax on income (there will normally be additional tax on income when profits are extracted from the company – but see below). For Capital Gains Tax (CGT), the incorporation results in an up-lift in the base costs of all the properties meaning that gains at the time of incorporation are cleared.

A shareholding in a company is an asset that can be dealt with far more effectively and conveniently for Inheritance Tax (IHT) purposes than, say, a direct interest one or more properties and the opportunities for IHT planning are broad.

Given the obvious benefits, the only question is whether the incorporation can take place free of tax charge. The transfer of the properties into the company is a disposal for CGT purposes. There will, however, be no tax to pay if the conditions of ‘incorporation relief’ are satisfied. The main requirement for this is that there is a business (as distinct from a simple investment).

The acquisition by the company may be subject to Stamp Duty Land Tax (SDLT) even though no cash consideration is paid. There may be no SDLT if the properties are transferred from a partnership. Can ownership between husband and wife constitute a partnership for these purposes? Frequently, it can.

The final concern is whether the lender will agree to the transfer.

The result

The rental portfolio clearly constituted a business for these purposes given the significant involvement of the parties. Even though the couple had never registered or returned the business as being operated in partnership, HMRC accepted the existence of a partnership. This was on the basis that a partnership exists wherever two or more people operate together with a view to making a profit. From then on (i.e. for the period immediately prior to the incorporation) a partnership return was submitted. Lender permission was not required because of the precise legal mechanism adopted.

As part of the incorporation, it was possible to create a Directors’ Loan Account (‘DLA’) of £1.3 million (being an amount that the couple could withdraw from the company with no additional tax charge).

The DLA produced an absolute tax saving of £273,000* on future income with an additional deferral of tax on retained income. The gains on the properties were eliminated in the ownership of the company, ultimately saving up to £392,000*. The clients will now be able to make gifts of shares into trust for children or to transfer the future growth value to children using a ‘Family Buy-Out’

(*) Based on applicable tax rates and policy in the 2020/21 tax year

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