CAPITAL GAINS TAX - PROFIT EXTRACTION - 08.09.2020

Small business incorporation - minimising tax without BADR

Your business is growing steadily and your accountant has advised you transfer it to a company to save income tax. For maximum tax efficiency should you do this immediately or delay?

Profit extraction

In recent years the government has taken steps to curb the tax advantages of running a business through a company, nevertheless income tax savings are still possible for owners of small businesses who make the move. Your profits need to reach a certain level, which can vary a little depending on your circumstances, before transferring your trade to a company is tax efficient. When the time is right there’s even a trick you can use to get another tax saving in the transfer process.

Tip. Selling the goodwill of your unincorporated business to your company instead of transferring it for no payment means you’ll pay capital gains tax (CGT) at the maximum rate of 20% rather than income tax on rates up to 45% on anticipated company profits.

Trap. It’s no longer possible to claim the business asset disposal relief (BADR) (formerly entrepreneurs’ relief) CGT rate of 10% for gains made from selling the goodwill of your business to a company you own.

For detailed commentary on the conditions for BADR to apply, visit http://tipsandadvice-tax.co.uk/download (TX 20.21.03).

10% tax by the back door

While you can’t achieve the 10% BADR tax rate for the gains made from the sale of goodwill you can, with careful tax planning, get the same rate for at least some of the gain. Since 6 April 2016 normal CGT rates start at 10%. This rate applies to gains which, when added to your income for a tax year, don’t exceed the income tax basic rate band - currently £50,000. Gains above that are taxed at 20%. The rest of the planning is down to timing.

Example - bad timing. In March 2020 Mary incorporated her business. Her company paid her £70,000 for the goodwill. Having started the business from scratch the whole of this sum is a capital gain. Mary’s profits for 2019/20 were £55,000, i.e. they exceeded the basic rate band, meaning that the whole capital gain, after knocking off her annual exemption (£12,000), was taxable at 20% resulting in a tax bill of £11,600.

Example - good timing. Had Mary ceased her unincorporated business on or just before 5 April 2020, i.e. in 2019/20, and sold the goodwill to her company soon after 5 April 2020, i.e. in 2020/21, she could have reduced her CGT bill to £7,880. A saving of £3,720 compared with the previous example. However, to achieve this she must not draw taxable income from her company in 2020/21. This doesn’t mean that she has to live on thin air for the remainder of the year. She can instead use the money from the sale of her goodwill.

How it works in practice

The profits arise in the company and aren’t taxable on Mary until she draws them. Her CGT bill on the sale of her goodwill, after knocking off her annual exemption (£12,300), is 10% on £37,200 and 20% on the balance of £20,800. The company paid for the goodwill by crediting Mary’s director’s loan account, meaning it didn’t need to find the cash. As the company generates profits Mary can draw the cash, but not as taxable salary or dividends, but on her £70,000 non-taxable director’s loan account balance.

The best time to transfer your unincorporated business to a company which you own or have a significant stake in is usually just at the start of a tax year. That way you can substitute taxable income, e.g. salary, with the money the company pays you for your business which is only subject to lower capital gains tax rates.

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