For a variety of reasons, many trading businesses and professional practices are currently looking to incorporate their business; from the protection that limited liability provides, to the opportunity to access many potential tax benefits, including:
To take advantage of the relatively low corporation tax rate of 20% on business profits versus the top rate of income tax of 45%.
To enjoy greater control and flexibility over how and when profits are extracted, and therefore taxed on withdrawal, from the business.
To have the opportunity to crystallise and access the value of goodwill built up in the business in a tax efficient way.
Where Capital Gains Tax Entrepreneurs’ Relief is available, owners can sell the goodwill to the company and suffer tax at a reduced rate of 10%. The sale consideration can be credited to a directors loan account in order that this amount can be drawn down with no further tax in future, financed from future profits.
While the sale of goodwill is a very attractive proposition, care must be taken. The valuation of goodwill is subjective and complex to calculate, with a variety of different methodologies existing in order to arrive at the market value goodwill of a business.
HM Revenue & Customs (HMRC) are taking an increasingly hard line on the creation and valuation of goodwill, and any excess consideration could give rise to serious income tax implications for the individual business owners. Any overvaluation of goodwill could render the excess valuation amount liable to income tax at 45% as opposed to Capital Gains Tax at 10%. Evidence of a professional valuation undertaken to arrive at the market value of goodwill should therefore be retained in order to defend against any challenge from HMRC.
Care also needs to be taken where the goodwill is wholly or partly attributable to the skills, abilities and personal attributes of the business owners. Personal goodwill cannot be transferred/sold and HMRC are prepared to challenge the nature and value of this type of goodwill on incorporation.
There is no doubt that the sale of goodwill upon incorporation can be very financially attractive and tax efficient, but the impact of getting things wrong can be extremely costly. Specialist valuation and tax advice is therefore essential when any incorporation is being considered, particularly when goodwill is an important element.
Stuart Petrie is tax senior manager at Anderson Anderson &Brown LLP, Chartered Accountants.