If you have decided to transfer your sole trading business to a limited company the reasons will often be tax focussed and you will have considered the tax implication of doing so. Of course, you will wish to choose the most tax efficient option available to you and when transferring your business the most tax advantageous way, it’s all in the timing.
One way of withdrawing money out from your new company is by transferring (selling) the goodwill generated in your unincorporated business (as a sole trader) to the limited company. This creates a loan within the new company that you are then able to draw out once there is enough cash.
Whilst capital gains tax is payable on the goodwill asset sold to the business (and in the year it is sold), the tax rate payable on capital gains is less than that paid on income.
Anti-avoidance rules prevent business asset disposal relief (BADR) applying on capital gains made from transferring goodwill from an unincorporated business to a limited company. But it is still possible to achieve a 10% tax rate, here’s how!
Goodwill is generated by selling a business that is a going concern and represents a certain value (and potential competitive advantage) that may be obtained by one company when it purchases another. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.
There used to be a capital gains tax advantage from transferring the goodwill generated in an unincorporated business to a limited company. Almost a decade ago the government blocked this advantage and introduced anti-avoidance rules.
Individuals were able to transfer the value of goodwill to their new limited company by crediting their directors loan account with the value of goodwill generated from their business as a sole trader, creating a directors loan.
They were paying capital gains tax on their sale of asset at the BADR rate after knocking off their capital gains tax exemption. This meant they could draw out the loan as payment for goodwill rather than paying themselves a wage through their new company in the start up stages until the loan was fully repaid. Tax was paid on the capital gain in the year it was sold but tax was paid at a much lower rate than if it was taken as a salary or dividends, depending upon the value of goodwill.
Limited company set up – All in the timing
While the tax break using BADR is no longer allowed, a 10% tax rate might still be possible when transferring goodwill to a limited company. This is because in 2016 the standard corporation tax rates were reduced from 28% and 18% to 20% and 10% depending on the rate of income tax that applied.
By setting up your limited company and transferring your business early in the tax year rather than at the end and drawing on the directors loan rather than taking a salary or dividends, some of the capital gain on the value of the goodwill transferred to the company will be fall in the basic rate band and so an equivalent part of the gain will be taxed at 10%.
When calculating the capital gain (goodwill), market value is substituted for the actual consideration where the parties are connected and where the price paid for goodwill exceeds market value, the excess amount may be treated as a dividend. Determining the value of goodwill is not as straight forward as it would seem.
Depending on the circumstances, incorporation relief or gift relief may be available to defer the gain.
For further information regarding capital gains tax or any other topic, please contact us https://www.argyleaccountingltd.com/contact-us/
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