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August 2010 The various types of legal structure for a business can be mind boggling to both new business start ups and to existing businesses. This article summarises the main options available and the tax implications of each. Tax, however, is only one part of the question and other factors such as risk mitigation and commercial issues are of equal, and on some occasions of greater, importance. Sole Trader This is one of the common arrangements were an individual wishes to carry on business by himself. It is frequently used for business start ups. In these circumstances an advantage of such an arrangement is that under certain circumstances any trading losses can be set against other taxable income of the individual. In the initial stages of a new business it would not be unusual to have trading losses and the ability to use these against other taxable income and secure an Income Tax refund is beneficial. Income Tax and National Insurance is payable on taxable profits “earned”. The top rate of Income Tax is currently 50% and whilst National Insurance is payable at 8% it is capped at 1% for profits over £43,875 (2009/10). The fact that tax is payable on profits earned can result in cash flow problems as the profits in some businesses will be tied up in working capital such as debtors or may be reinvested in equipment or property. If the business has fixed assets, such as property, that it sells at a profit then any Capital Gains Tax can be at a reduced rate of 10% if the gains qualify for Entrepreneurial Relief. The maximum rate of Capital Gains Tax can be high as 28%. If the business is particularly acquisitive and buys other businesses and pays for goodwill in the process, no tax relief will be obtained until the business is sold. This is a disadvantage and can be contrasted with the position of a Company described below. Unfortunately the enhanced tax reliefs available for Research and Development expenditure are also only available to Companies. Partnership A Partnership is a collection of two or more persons. The tax position of a business trading as a Partnership is similar to that of a Sole Trader in that the Partnership is transparent for tax purposes. Any income or gains are taxed on the Partners by reference to their profits sharing ratios. The same rates of Income Tax and Capital Gains Tax apply. By way of note a Company could also be a Partner in a Partnership and there are some more sophisticated arrangements involving Partners who have limited liability. Company It is not uncommon for a business to operate initially as a Sole Trader and develop either into a Partnership or incorporate as a Company. Equally a business can start as a Company. Companies fall into two types, a Limited Company or an Unlimited Company. The former is the more common of the two. The entrepreneur is likely to be both a shareholder in the Company and also a Director. The Company will pay Corporation Tax on income profits and capital gains at a tax rate of 28%. This rate is reduced to 21% if the Company meets certain conditions and the taxable profits are less than £300,000. Many family companies in Northern Ireland will fall into this second category. The entrepreneur can be flexible with how profits are extracted from the Company and the following are a few examples: salary; benefits; loans; pension; or dividend. Each is taxed in a different way and depending on the particular circumstances the tax effect of one may be much less than the tax effect of another. When a Sole Trader or Partnership generates higher levels of taxable profits they will often look to incorporate the business so that they carry out business in a Company. This can lead to substantial tax savings both at the time of incorporation and on an ongoing basis. From a tax perspective the benefits are: goodwill can be sold to your new company at a tax rate of only 10% to be drawn down on later; profits can be retained in the Company and taxed at only 21%; profits can be extracted by way of dividends which can be tax efficient and the entrepreneur’s spouse can also be a shareholder and receive a tax efficient dividend. If the Company buys another business and purchases goodwill, the cost can be relieved for tax purposes over a period of time reducing the after tax cost of the acquisition. Companies also get enhanced tax relief for Research and Development expenditure. A significant downside for a Company arises when property is being sold and there are capital gains. If the entrepreneur wishes to extract the profits following such a sale there are two levels of tax. Firstly, the Company will pay Corporation Tax on any gain and secondly the individual will then pay Income Tax on any salary or dividend extracted. If the property had been owned by a Sole Trader or Partnership then only one level of tax would be payable. A Company would not be my first choice as a vehicle for purchasing property. If the Company makes trading or capital losses it is not possible to set these against other taxable income of the entrepreneur, they can only be used by the Company. Limited Liability Partnership (“LLP”) The LLP is a hybrid in that it is a Body Corporate and legally has many of the beneficial characteristics of a Company but is also transparent for tax purposes as it is effectively taxed as a Partnership. In some ways it can be regarded as the best of both. It is best to think of an LLP as a Body Corporate owned by Members and the Members are taxed as Partners would be taxed in a partnership. Sophisticated arrangements can also be implemented to maximise the tax benefits of an LLP. One common arrangement is to have a Company as a Member along with other individual Members. Under such a structure: capital gains can be allocated to individual Members and avoid the double taxation issue of Companies; and income profits that are to be retained can be allocated to the Corporate Member and taxed at only 21%. Summary It is impossible to be prescriptive about one structure over another, as usual it depends on the individual circumstances at the time and equally important what the future intentions are. It is the role of the adviser to make the client aware of the options and the tax implications that would arise. Taking these into context with commercial factors will allow the entrepreneur to mitigate his overall tax position. A new Prime Minister and a coalition Government is in place. We await what has been promised as an austere budget approaches but rather than add to the speculation we should focus on what we do know and what is within our control. We do know the Conservative Party plans to increase the IHT Nil Rate Band to £1,000,000 have been shelved and that estates in excess of £325,000 in value continue to attract tax at a rate of 40%. Many see this as a tax on assets that have already been taxed. This combined with the mindset that taxes are squandered has given rise to a flourishing “industry” with the objective of designing arrangements to mitigate exposure to IHT. The following will put the cost of IHT in perspective: Estate Inheritance Tax exposure The current trend in this field is to use offshore trust arrangements or rely upon pension structures to avoid UK tax. The technical arguments and opinion from Counsel might be difficult for clients to fully understand, but their flexibility is attractive. Solutions can be structured to: reduce UK IHT; allow assets to be transferred without triggering Capital Gains Tax; allow the individual to continue to enjoy the assets; and allow the assets to be protected from family disputes and insolvency. Every client’s circumstance is different and it is important to tailor solutions for each client. For example: a) children of the client may have special needs; The approach to IHT planning can be analysed in a number of stages: The number of potential solutions and distinguishing between each can be confusing. The skill is in selecting a solution that is appropriate to client’s circumstances. Whilst there is no one solution fits all we would like to leave you with a few thoughts: We hope that the above will encourage you to at least establish what your IHT exposure is and determine whether or not action is necessary. Alan Curry is a Tax Director with ASM Howarth. He can be contacted by phone on 028 9024 9222, online at www.asmhorwath.com or by email The content of this article is provided for information purposes only and does not constitute professional or other advice. A Guide To Tax Survival Taxpayers should start to plan now for how they might best mitigate their tax liability. Your accountant should be familiar with your circumstances and the following are topics that you might wish to raise. Avoiding needless penalties Obtaining a financial review Do you have a Will or Enduring Power of Attorney in place or have you undertaken some retirement and inheritance tax planning? In respect of the latter the starting point is to have the IHT exposure quantified. An adviser will then discuss the various options available to you which will include: making lifetime gifts or gifts out of income; using trusts or family limited companies; restructuring assets to attract IHT relief; or even arranging life assurance for a period. Hindsight and legal matters Review of business taxes Losses are becoming increasingly familiar but they can have some use. It is possible to make a claim to reduce corporate and personal tax payments. Indeed in certain circumstance this can lead to tax refunds. There continues to be a tax differential between the UK and Republic of Ireland rate of corporation tax and restructuring the business so that profits generated in the Republic of Ireland are taxed only there can mitigate tax. Capital allowances now compromise a combination of Annual Investment Allowance, Integral Features Allowance, Writing Down Allowance and “Green Technology Allowance”. It is more important than ever to engage with your tax adviser before embarking on a capital expenditure program. Your business structure may no longer be tax efficient or protect you from financial risk. Have you considered alternatives such as incorporation or a Limited Liability Partnership? Alan Curry is a Tax Director with ASM Howarth. He can be contacted by phone on 028 9024 9222, online at www.asmhorwath.com or by email The content of this article is provided for information purposes only and does not constitute professional or other advice.
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