AITI Chartered Tax Adviser

What are the issues on transferring a business to a company in relation to corporation tax?

Business growth

Your decision to transfer a business to a company should be based on sound commercial reasons, not short-term tax saving. The critical issues are:

(a) How much is your business going to grow? If your turnover is going to grow from zero to €800,000 in 12 months (with profits of say €300,000), and continue growing rapidly, then it makes sense to have the profits taxed at the rate of corporation tax (12.5%). If the business is fairly stagnant (turnover of €50,000 with little growth), it makes sense to leave it as a sole trader business.

(b) Would you be better off using initial losses against your personal (sole trade) income, rather than have initial losses carried forward for relief against future profits of the company? This decision needs to be balanced against the protection of limited liability.

(c) Do you intend to leave profits in the company, or pay them out regularly in the form of salary or dividends? If you intend to extract all of the profits, then those profits are taxed at up to 40% in the hands of the shareholders unless the shareholders (or a majority of them) are non-resident, in which case they will pay tax on the dividend in their home country. If you do not intend to extract all of the profits, the company can be used as a savings box to build up funds for new business ventures. Such retained profits are not liable to surcharge as in the case of retained investment, rental and service company income.

Level of drawings

Transferring a business to a company can save cash flow if your drawings are significantly less than the company’s profits – in other words, if the profits are allowed to build up in the company.

Advantages of incorporation

The main advantages of carrying on your business through a company are:

(a) Lower tax rates. The general corporation tax rate is 12.5% (this rate also applies to foreign trading dividends from an EU/Treaty country). This compares with a marginal income tax rate of 40%, PRSI of 4% and universal social charge of up to 11% depending on the income. A company does not pay PRSI or USC on its profits.

A new start-up company can get a three year exemption which effectively reduces its annual tax charge of up to €40,000, to nil. The relief is linked to the amount of employer’s PRSI paid by a company, subject to a maximum of €5,000 per employee, and an overall limit of €40,000. Service companies and 25%-taxed trades do not qualify.

(b) Pension funding. A company can get a deduction for contributions made to your pension scheme. Generally, the maximum value a fund can have is €2.3m.

(c) Interest relief on money you lend to, or invest in, the company.

(d) EIIS relief on money invested in the company – assuming the company qualifies for relief. However, you cannot hold more than 30% of the company’s ordinary share capital unless you are a seed capital investor or the company capital is less than €500,000. Interest relief is not allowed on money borrowed to make a EIIS investment.

(e) Your company can employ your spouse and children. Each can have their own tax allowances and PRSI limits. If €100,000 was earned by a company and split among four adult employees, the total tax bill would be lower than the income tax charged on one person with married rate bands. See Chapter 1.

(f) Limited liability. In practice, this is not much advantage as bankers and key suppliers may require personal guarantees from the shareholders and/or directors in respect of company debts.

(g) Group losses. A company which is part of a group can use a loss of a fellow group member against its own profits.

Disadvantages of incorporation

The main drawbacks of carrying on your business through a company are:

(a) Double charge. This is also known as the profit-extraction problem. Your company pays tax on its profits (income and gains) and you, as shareholder, pay income tax on any dividend or income you take from the company. Therefore, you could end up paying tax a 40% on a gain on which the company has already paid tax.

(b) Close company surcharge. Undistributed rental and investment income of a close company is liable to a 20% surcharge. Undistributed income of a service company is liable to a 15% surcharge (on half the undistributed trading/ professional income). The surcharge, if paid, is wasted money, as you cannot even credit it against income tax liability when the income is distributed.

(c) Strict Schedule E expense rules. A company director has fewer expense deductions than a self-employed person. Against this, you can access share incentive reliefs (share options acquired through a save as you earn scheme, shares acquired through a profit sharing scheme, and shares bought through a share purchase scheme).

(d) Benefit in kind. This may be treated as a distribution of profits liable to dividend withholding tax (DWT).

(e) Excessive interest. This can be treated as a distribution liable to DWT.

(f) Cost of incorporation and annual audit and filing fees. This can run into thousands of euro. There is also the time and cost of taking minutes of directors’ meetings, and loss of confidentiality. You must file your company accounts with the Companies Office where they can be inspected by anyone.

A company is exempt from the requirement to have its accounts audited if its turnover is less than €1.5m.

A “small company”, need only file an abridged balance sheet. A company is “small” if it meets any two of the following conditions:

(i) Turnover does not exceed €3.81m,

(ii) Balance sheet total does not exceed €1.9m, and

(iii) The number of employees does not exceed 50.

A company with unlimited liability is not obliged to file accounts.

Cessation of sole trade

If your sole trade business has completely ceased, your profits for the final tax year and the penultimate tax year of trading are revised to actual. This may give rise to additional income tax liability for you.

You may not carry forward sole trade losses into the company. It may be possible to claim terminal loss relief, and use the loss in the final year against income of the three preceding tax years. If there is no such income (the sole trade has always lost money), but there is a prospect of profits in the near future, it may be better to wait until the sole trade makes a profit and to use up the losses carried forward before incorporating. Otherwise, the tax value of the losses will be wasted.

If you transfer stock of your ceased sole trade to your company, you must value such stock at sale price or transfer consideration. This allows you to transfer such stock at book value.

The sole trader and its successor company may jointly elect that no balancing adjustment will be made on plant and machinery transferred. The plant and machinery will transfer to the company at their tax written down values.

If you retain an industrial building in personal ownership, you are treated as if you had sold the relevant interest at open market value on the date of incorporation. This will give rise to a balancing adjustment.

Capital gains tax on transferring your business to a company

If you are aged 55 or over, you can claim retirement relief even though you are continuing to run the business through the company. Provided you fulfil the 10 year ownership requirement, and the transfer is for bona fide commercial reasons (the desire for limited liability presumably meets this test), you can transfer assets to a value of €750,000 to the company without giving rise to any CGT liability.

If you are too young to claim retirement relief, or you do not meet the 10 year test, you can claim a deferral of any CGT liability arising on transfer of your business to the company. In effect, the value of the company shares will be depressed for CGT purposes, so that when you come to sell the shares, the in-built gain will crystallise.