In recent years there has been a substantial increase in the proportion of independent practices being run as limited companies. Many of these practices started life as the self-employed vehicle of the owner and when the practice accounts were prepared each year, tax and national insurance was payable on all of the profits generated. This meant that the vast majority of the profits were being taxed at the higher rate of tax of 40 per cent, with no tax planning strategies to reduce this figure if the owner wanted to re-invest his profits and build up the practice in the future.
The actual process of transferring the business to a limited company can seem quite tricky to the uninitiated at first, but in practice can be dealt with quite easily with the help of an experienced adviser.
How to transfer the business
Effectively the business is 'sold' by the owner to Newco Ltd in return for shares. The bad news is that the sale value is subject to capital gains tax of 10 per cent as it qualifies for 'entrepreneurs' relief' and the tax must be paid as the price for incorporating.
However, the good news is that the new limited company now has a debt to its new shareholder and can repay this debt from future profits in the business without having to deduct any tax. This is especially useful when tax rates are increasing and personal allowances for higher rate taxpayers are being eroded, as they have been for the past few years.
For serial entrepreneurs, the good news under the recent budget is that the lifetime limit of gains that can qualify for entrepreneurial relief has been doubled from £5m to £10m. This is especially good news as, up until 2009/2010, this limit was only £1m and there were fears it would be scrapped altogether.
Extracting funds tax efficiently
It is interesting to see what a taxpayer ends up with in their pocket if they distribute £100,000 of profits during the current 2011/2012 tax year.
It can be seen from the table that there is over £5,000 of additional after-tax income for the owner if he incorporates. The figures for the limited company are based on paying £7,228 as a salary and then the company having a corporation tax liability of 20 per cent on the profit less salary.
The balance of the profits after tax are then paid as a dividend to the owner. The additional after-tax income available for the shareholder of a limited company comes primarily from the fact that there is no national insurance liability on either the first £7,228 of salary or on the dividends drawn.
Growing the business
A further major advantage of running the business through a limited company is that, if funds are to be set aside to grow the business in the future, (say by taking on more staff and renting a bigger high street store), then the company need only suffer corporation tax at 20 per cent on the funds not distributed. This leaves 80p in the pound that can be re-invested.
If the practice was being run as a self-employed business, the effective higher rate of tax and NI could be as much as 42 per cent, leaving only 58p in the pound to be re-invested.
Motivating key staff
Keeping hold of key staff for the future is always a major issue for business owners. One very tax-efficient means of motivating staff to stay can be the issue of share options in a limited company. A key employee could then be promised, say, 10 per cent of the practice's shares if they meet certain criteria, such as staying for over three years and increasing turnover by 15 per cent.
Limited liability
One of the major advantages of being incorporated has traditionally been to benefit from limited liability. This means the owner and the business are separated from any action, should the company be unable to meet its debts. However, it should be noted that, in the current economic climate, most lenders will seek personal guarantees from the owner as they are scared that the limited liability status may expose the lender to losses in the company.
Company cars
The general rule here is that the owner's cars should not be run through a company, as the level of personal taxation is prohibitive. Effectively the driver will face a benefit in kind tax charge of 35 per cent of the list price of the car each year, as well as being taxed on having the benefit of private fuel charged for.
The recent budget increased the tax-free mileage allowance that can be paid to employees from 40p to 45p per business mile and, as long as a mileage log is maintained for all business mileage, then it makes sense to own cars personally to avoid personal tax and NI liabilities.
Disadvantages to incorporation
While incorporation under the current tax regime will usually result in higher net income for the owner as set out below, there are some further considerations which should be reviewed before any final decision is made:
? Costs of compliance. Additional professional fees will need to be paid to cover accounts, company tax and company secretarial matters
? Losses. In the early years of a business, losses may be generated. In this case, starting off as self-employed would result in being able to get a personal income tax refund from the losses. Unfortunately, losses in a company can only be carried forward against later profits of the same trade
? Tax on business sale. If instead of the owner selling the shares of the company, the company sells the business goodwill, then there lies the risk of double taxation firstly the company will be faced with a corporation tax bill on the profit it makes from selling the business and secondly the owner will be taxed when he tries to extract the net gains from the business.
The budget and tax planning ideas above are not comprehensive and each practice should carefully review with specialist advisers whether they can be applied to their own business and their own individual circumstances. ?
? Marc Bennett is the managing partner of AEL Partners LLP, which specialises in providing solutions to tax, VAT and accounting issues affecting independent opticians. He is a council member of the BCLA and has written numerous articles as well as lecturing on practice valuation and tax planning opportunities for opticians. He can be contacted at A+E+L on 0207 433 6940 or by email to mb@aelp.co.uk
