Company tax law can trip up a firm and its owners regardless of the business sector it operates in. Helen has the story.

IN March 2022 one case involving a care home may have been miles away from the world of flooring, but it nevertheless highlighted some of the hazards and pitfalls of incorporation.

Having run as a partnership for about 14 years, in 2009 the owners followed their accountant’s advice to incorporate as La Luz Residential Home Ltd.

However, it doesn’t appear the owners familiarised themselves with the implications of incorporating and their duties on becoming directors. In fact, despite the change in its legal status, the home carried on largely as before, with transactions continuing through the partnership bank account, and the businesses suppliers and customers unaware of the company.

Compounded by other tax issues, this laissez-faire approach resulted in substantial tax labilities and penalties which will potentially run to six figures for the owners.

Why incorporate in the first place?
Selecting the appropriate business structure is an important decision and it is not uncommon for a business to start as either a sole trade owned and operated by one person, or a partnership where there are two or more people, before incorporating into a company once the business is established and growing. Incorporation involves the creation of a new legal entity to which an existing business can be transferred. This is a step with wide-ranging consequences and any business needs to consider carefully whether it is suitable to their circumstances.

One of the common motivations given for incorporation is the potential to save tax. Sole traders and partnerships will pay tax on profits as they arise (whether or not they draw them out of the business) at income tax rates of up to 45 percent, with a further cost of national insurance contributions. In contrast, a company is subject to corporation tax on its profits in its own right and then the shareholders are taxed personally on any money that they take out of the company.

Although this means there are two layers of tax – first corporation tax and then personal tax on dividends, salaries or interest on loans made to the company – historically, the lower rates of corporation tax and the ability to leave profits within the company meant that incorporation could result in net savings.

In recent years, changes in dividend taxation have eroded the tax savings for many and the increase in corporation tax from 19% to 25% in 2023 for those with profits of more than £50,000 has increased the tax burden. It’s important therefore that a good deal of number crunching is undertaken to see what, if any, savings might still be possible.

Outside of tax, the second key advantage of incorporation is the protection of limited liability. Unlike a sole trader or partnership, the shareholders in the company aren’t usually liable for the company’s debts. This helps to reduce the personal liability for shareholders. If the company becomes insolvent, generally only the money that the shareholders have invested in the company is at risk unless they have given personal guarantees (to the company’s bank for example) or have been shown to have been negligent or acted fraudulently in their capacity as directors.

Other less significant benefits include the perceived ‘prestige’ of running a company and the potential to delay the transition to making tax digital, as this isn’t due to take effect for corporation tax until 2026 at the earliest.

Separate entity
For those that decide to incorporate, the most important point for any business owner to understand is that the new company will be a separate legal entity. The company will need its own bank account and the funds in that account will belong to the company. A company is owned by the shareholders and run by directors and although in a small business these are often the same people, the assets of a company belong to the company, and the director-shareholder can’t use the company account as their personal piggy bank, even if they own 100% of the shares.

If the director wants access to cash held by the company, then they will need to pay themselves a salary or vote dividends, both of which will have personal tax consequences for the individual. (There is also the potential for a director’s loan, discussed below.)

Paying a director a salary may also require the company to operate a payroll and register for PAYE with HMRC, increasing the administrative burdens of the business.

Where a business owner struggles with differentiating business and personal expenditure, then incorporation may not be a suitable option as it can be very easy to get into a mess.

Transfer of assets
On incorporation, a decision must be taken regarding what assets of any existing business are to be transferred to the new company. The transfer of assets such as property, plant and machinery can all have tax consequences, with the potential for capital gains on transfer of property or goodwill and capital allowance charges for the transfer of plant and machinery. There are reliefs and elections available to mitigate the tax costs of incorporation, but certain conditions will need to be met and advice will be needed to decide on the best outcome.

Particular care needs to be taken with assets which are used both in the business and personally, and also with land and property. Both of these areas caused problems in the care home case.

A common example of an asset which can be used both personally and for the business is the director’s car. If the director transfers their vehicle to the company as part of the incorporation or gets the company to buy a car which they can use privately, then a benefit in kind will arise which is taxable on the director. It is often simpler and more cost effective for the director to keep their car and recover business mileage at the approved mileage rates, although this does require the director to keep records of their business mileage. If clear records of business mileage are not retained, as happened in this case, then HMRC may challenge the level of reimbursement the director can receive from the company without tax consequences.

Whether or not to transfer property such as trading premises into the company is also a big decision with a lot of competing factors to consider. If the decision is taken to transfer in, then there will be upfront costs including fees for transferring any mortgage to the company, and taxes such as stamp duty land tax (or LBTT/LTT in Scotland and Wales) and capital gains tax – although reliefs might be available in certain cases.

The property will also form part of the company’s assets in the event of a claim against the company. But if the property is kept out of the company – which may allow for the charging of rent and help protect it from claims against the company as well as being simpler – that could reduce the availability of business property relief (BPR) in the future and claims for tax reliefs on future sales could be affected. BPR is a very valuable relief which can exempt up to 100% of the value of qualifying assets from inheritance tax so again this is something where care and advice is needed if the intention is to pass a property down the generations.

If the decision is taken to transfer any property to a company, then this must be correctly documented by a solicitor. In the case above, the care home owners were unable to evidence details of the transfer of a rental property which they claimed the company owned. The tribunal therefore decided they still owned it personally. This had knock on consequences for tax as the company had spent money on the property. Since the property did not belong to the company it was entitled to recover this money from the directors.

Overdrawn directors’ loan account
One consequence of failing to keep company and personal expenditure separate can be an overdrawn directors’ loan account. This can have tax consequences for both directors and company and, if this is not spotted early or extra costs are identified as personal at a later date as happened in this case, there’ll be interest and penalties to pay in addition.

If the director has put money or assets into the company then the company owes the director and it can, when there are funds available, repay its debts to the director. The problem arises where a director draws more money out of the company than the company owes them, which is effectively treated as a loan to the director. If this loan is not repaid within nine months of the company’s year end, the company must pay what is effectively a penalty charge of 32.5% of the amount overdrawn at the year end to HMRC.

This can be recovered in time – but only once the director has repaid their loan account. Either the director will need to transfer money (or assets) back to the company or vote themselves more dividends or salary – which will have a personal tax consequence – to give them the funds to repay the loan.

If the director is overdrawn by more than £10,000 at any time during the year, they must also pay interest to the company at a minimum rate set by HMRC – currently 2% – or be assessed to a benefit in kind.

Informing customers and suppliers
It’s important to inform customers and suppliers of the business that the business has incorporated as they need to know they are now dealing with a different legal entity. In addition, all websites, email signatures, letterheads, stationery, invoices, order book, etc all need to be updated to show the company’s name, where it was registered (England & Wales, Northern Ireland, Scotland or Wales), the registered number and the address of the registered office. A company that does not disclose all the details required risks fines for both the company and the directors. Again, this was a step missed in the case, which provided further evidence to the tribunal that the directors were not taking adequate care.

Companies operating in regulated sectors might also have other obligations about disclosure of the company details to meet.

Statutory duties
As flagged by the judge in the case, ‘becoming a director of a limited company brings with it a range of fiduciary duties which it is important to understand’. A company director must fulfil, by law, certain responsibilities to the company. These include acting to promote the success of the business and exercising reasonable skill and care as well as avoiding or managing conflicts of interest between what is for the benefit of the company and what would benefit the director personally. Failure to do this can result in serious legal consequences for the director who might be held liable personally for any failures to uphold their duties.

Companies House and company accounts
Company accounts are more formal than partnership accounts and need to be prepared in accordance with specific reporting standards and filed with Companies House where they are then made publicly available.

Although, particularly for small companies, the amount of accounting information which is provided to Companies House isn’t great, there will be some loss of privacy, and personal details about the directors and controlling shareholders will also be publicly available. Directors need to ensure details held by Companies House are kept up to date.

A further consequence is that company accounts are generally more complex and expensive to prepare, so the business will need to be prepared for higher administration costs arising from the requirement to prepare statutory accounts, as well making other Companies House filings required by law such as the annual confirmation statement.

Tax complexity
In addition to preparing the company accounts, the company will need its own corporation tax return while it is very likely that the directors will continue to need to complete and file personal tax returns via self-assessment to report salary, interest or dividends paid by the company.

In summary
While there are tax reliefs to assist the process of incorporation, there are few reliefs for going the other way if the business later decides to disincorporate and return to a sole trader or partnership structure. It’s also more expensive to wind up or liquidate the company if it’s decided it’s no longer needed.

It’s therefore important sole traders and partnerships carefully consider the pros and cons, and get professional advice, before making the leap to incorporation.
www.att.org.uk
Helen Thornley is a technical officer at the Association of Taxation Technicians