New tax a wind-up for small firms

Tax is one of the biggest headaches for small businesses, so the announcement in the recent Budget that the corporation tax rate on the first £10,000 of profits has been increased from zero to 19 per cent brought little cheer.

Sole traders now face the question of whether it is still worth incorporating - that is turning a business into a limited company. Should small businesses already incorporated wind up, given that disincorporation can be expensive and complicated?

Corporation tax


Two years ago, in an initiative to encourage business, Chancellor Gordon Brown cut corporation tax (the tax a company has to pay) to zero on the first £10,000 of profits. Since company directors were able to pay themselves a dividend from the company out of these profits, many took a low salary, which they topped up with dividends, on which they paid a lower rate of tax (in effect, no extra tax for basic-rate taxpayers and 25 per cent for those on the higher rate and no national insurance for either). As a result, the Treasury lost an estimated £500 million.

From the beginning of April this year the first £10,000 of profits are subject to corporation tax of 19 per cent if they are taken out of the company. So the director's dividends will attract a 19 per cent rate, although this doesn't apply if the profits stay invested in the business or are paid to another company. Nor does it affect companies whose taxable profit is more than £50,000. The good news is that the Chancellor did not levy national insurance on dividends, as some accountants had feared.

John Whiting, tax partner at PricewaterhouseCoopers says: 'The changes leave our smallest businesses with an extra calculation to make - I find it wrong fundamentally. Although people keep talking about a loophole, there has always been a difference between a company that is incorporated in tax and one that is not.'

Perhaps the tax cut two years ago was a clever ruse by the Treasury to encourage workers in the black economy to register as companies and enter the radar of the Inland Revenue. 'Limited company status is something we are being pushed towards by the government because it gets you on the system and out of the black economy,' he says.

Should your business incorporate?


Freelance workers may still decide to turn themselves into companies because agencies don't like to hire staff who could legally be classed as employees. Whiting says the main reason to incorporate is still the protection of limited liability - directors are not personally responsible for any company debts. 'It can also be useful if you plan to bring in other people,' he says. 'Directors often prefer to bring them in as minority shareholders, not partners.'

What about disincorporation?


Given that running the accounts for a limited company costs extra time and accountancy fees, many businesses may be tempted to disincorporate after the changes in the Budget. Whiting says they need to take care. 'There is the possibility of having to pay stamp duty if there is property in the company because the company's assets are effectively being sold to individuals. If the company has significant assets and they are transferred to the direc tor, there will also be a capital gains tax charge.'

Maurice Fitzpatrick, tax director and head of economics at accountant Numerica, says this is the major problem with disincorporation.

'There is a potential double tax charge,' he says. 'The company faces corporation tax on the capital gain made on the difference between market value of assets when they are sold and their original cost. In addition, the owner of the company faces a potential capital gains tax charge on the difference between everything that he gets and what he originally paid for the shares in the company.'

He says there is also the question of the potential value of goodwill - which is difficult to assess but adds to the value of what the shareholder or director has received. There is also little point in raising salaries as a substitute for dividends. 'It is not usually in the director's interest to pay himself a higher salary instead of dividends since the 19 per cent rate is still lower than income tax and employers NI contribution. The changes are an additional imposition but might not be as onerous as they first appeared, and are unlikely to tip the balance in favour of disincorporation.'

Capital allowances


Robert Langston, tax consultant with Grant Thornton, says most businesses can still save extra tax by incorporation, particularly if they intend to reinvest profits into the business. In addition, there are value tax breaks in terms of capital allowances because when a business invests in new plant or equipment it can offset the cost against its profits.

This year's Budget increased the tax relief on capital allowances from 40 per cent to 50 per cent for the smallest businesses in their first year of trading. Other businesses can claim 25 per cent relief for capital investments in computer supplies, hardware and phone systems, energy-saving equipment such as industrial refrigerators, safety equipment, thermal insulation on industrial buildings, and research and development projects.

For firms involved in property development, there is an enhanced capital relief available for cleaning up contaminated land, which can also be offset against company profits. Langston says: 'There are a number of specialist reliefs which can make a big difference to companies' operations, but not all directors know about them.'

Taking money out of the company


In years when profits are good there are also tax-efficient ways to take money out of the company or use it for investment. Langston suggests that buying property within the company may not be the best option. Individual directors wanting to invest in property could instead use their personal capital gains tax allowance of £7,800 a year, which companies do not have.

'It is important to take money out of the company in an appropriate fashion, for example increasing pension contributions or distributing benefits in kind to directors or other employers. It depends on what future plans are and whether it is worthwhile leaving cash in the company,' he says.