Using goodwill to save tax on incorporation

Incorporating a sole trader may happen for a number of reasons. For example you started a business on the side not sure whether it would work out and you wanted to reduce overhead costs initially. After a while the success is here and you want to make use of the lower taxes enjoyed by limited companies. Another reason could be that you had paid significant taxes prior to starting your business and because, as a sole trader you can offset trading losses against salaries in previous years, it makes sense to not incorporate right away if you know that your business will incur losses initially. Once the business starts to make a profit however, it makes sense to incorporate.

Incorporating means creating a company and having this new company of which you are the shareholder buy the existing unincorporated business from yourself. If the value of your business is say £100,000 you will make a capital gain of £100,000 and your company will have a goodwill of £100,000 on its balance sheet (assuming there are no fixed assets). Either the company pays you right away or most probably it credits the director's loan account allowing you to draw funds as they become available in the business. But why is it a good thing?

1. You make a capital gain of £100,000 but the tax you will pay is just 10% of the gain minus the annual allowance (£11,000 for 2014-15) thanks to the entrepreneur's relief.
2. The company now has a director's loan of £100,000 that you can draw at your convenience. If you draw more than £32,000 in dividends per year, it's a savings of 25% on dividend tax that you would have to pay upon distribution.  
3. But also, because goodwill amortisation is an allowable expense for the business (if you started your Sole Trader business after April 1st 2002), it will generate over the amortisation period (typically 5 to 10 years) a savings of £20,000 (20% corporation tax of the goodwill). 

There are a couple of things to keep in mind however:

1. When someone transfers his Sole Trader business to a Limited Company of which he is a substantial shareholder, the parties are treated as "related parties" and the transfer must be at market value. HMRC recommends that you ask them to carry out a valuation check by submitting form CG34 but it can take for ever to get an answer and when you get the answer you might find that their methodology is very different from yours...
2. While the tax savings is significant, you still need to pay the capital gain now compared to the dividend tax or corporation tax in the future. If you don't have the cash it's a problem! It might be worth it to borrow money. But you don't have to. You can also claim incorporation tax relief under Taxation of Chargeable Gains Act (TCGA 1992 s162) in which case the capital gain is postponed until the next exit. You lose the tax savings but it's still an option.

Keep in mind that it's your business and you can decide when to incorporate. You will need to balance the additional tax and National Insurance you pay while you remain a sole trader vs. the overall savings you make when you incorporate. Also, you need to ensure that you have saved enough from your business to make the operation possible at all (since you need to pay the reduced tax upfront).

MAJOR UPDATE DEC 2014: With effect from 3 December 2014 those tax savings are gone. Where goodwill is transferred to a close company and the transferor is related to the company the goodwill will not be treated as a relevant business asset. This means no relief is available for the amortisation. Additionally, entrepreneur's relief will not be available on the disposal of the goodwill or other intangibles on incorporation where the transferor or any associates have shares in the company. The gain on disposal of the goodwill will be taxed at the normal CGT rates of 18% or 28%.