Incorporation relief shouldn’t be overlooked for goodwill transfers

Incorporation using entrepreneurs’ relief has not been available for a number of years which means that whilst there can be other benefits to running a business through a limited company rather than as a sole trader, partnership or LLP, incorporation itself does not attract the large tax savings that were previously available.

There are however other alternatives available on incorporation which compensate for the lost tax relief. One possibility is to use incorporation relief, which has been much neglected in recent years.

Here’s how incorporation relief works:

When business assets (usually goodwill) are transferred by one or more individual into a limited company which is controlled by them, it is classified as a disposal for capital gains tax purposes; the disposal is deemed by HMRC to have taken place at open market value because the parties involved are connected and the gain arising will attract capital gains tax at the rate of 24% in the absence of any relief.

One relief available to trading entities is incorporation relief, which is effectively a deferral relief. The deferred capital gain is rolled over and offset against the cost of the shares acquired in the company, so any tax payable will effectively be charged when the individual eventually sells his shares.

The transferred assets are deemed to be acquired by the company at their open market value, and the heldover gain reduces the cost of the shares. This means there are tax advantages if the company sells assets, but only a tax deferral if the individual sells shares in the company.

Three conditions for incorporation relief to apply

There are 3 conditions which must be satisfied before incorporation relief can be claimed:

• The business transferred must be a going concern;
• All assets owned by the business (except cash) must be transferred to the limited company; if assets such as land and buildings are owned, which the owners do not wish to be transferred to the limited company, they should be removed into personal ownership in advance. If this is not attractive, the gift relief rather than incorporation relief can be considered;
• The consideration paid for the business assets must be wholly or partly in shares.

Worked example: Incorporation relief

The Smith Partnership is valued at £100,000 and the partners decide to incorporate into The Smith Company Limited, owned by the same individuals.

The gain on the transfer of goodwill is £100,000

Incorporation relief is calculated as the gain x the value of the assets received/ total consideration.

Assuming no consideration is received for the goodwill other than shares, the incorporation relief is £100,000.

The relief is automatic, with no formal claim being required, and it cannot be restricted in order to make use of the annual capital gains tax exemption. (This could be done however by taking a small amount of cash into a director’s loan account, which will create a chargeable gain that can be calculated to be equal to the capital gains tax exemption).

When the shareholders of The Smith Company Ltd eventually sell their shares, the chargeable gain will be increased by £100,000.

If however the company sells the goodwill for £100,000, it will have no gain because its base cost is the market value on acquisition; i.e. £100,000

If you would like to discuss incorporating a business, please contact Lesley Stalker by emailing partners@rjp.co.uk