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Goodwill on Incorporation

Newsletter issue - October 2012.

Trading as a company is generally more tax efficient for profitable businesses; the tax rates are lower and many tax reliefs are only available to companies. Certain professions which were previously prevented from operating as a company, such as solicitors, can now incorporate.

If your business is loss making it may be better to remain as a sole-trader or partnership until those losses are fully relieved.

When incorporating a business, great care should be taken over the value of assets which are transferred to the new company, including the business goodwill. It is generally fairly easy to value fixed assets such as buildings or equipment, but goodwill of the business will depend on a number of factors and may not exist at all for some businesses. Examples of factors to consider include:

  • Reputation of the business;
  • Ability to generate future sales or fees;
  • Customer & staff loyalty; and
  • Location of the business.

A common approach is to estimate the capitalised value of the future profits of the unincorporated business and adjust for non-recurring items of income or expenditure. Adjustments will also be required for differences between the structure of the old partnership and the new company. The directors will be paid a salary, whereas the former partners took a profit share. Interest on borrowings will be paid by the company instead of by the partners.

Once a goodwill figure is established it can be included as part of the price to be paid under a sale agreement that transfers the business to the company. It is a good idea to include a price adjuster clause in this sale document, so if the Taxman challenges the value of the goodwill any outstanding amount of sale proceeds due to the former owners can be adjusted.

Where the former owners become directors of the new company, it is common practice to leave part of the sale proceeds owing to those individuals as loan accounts within the company. These loan balances can then be drawn down gradually from the company with no tax to pay. However, the former owners may have to pay capital gains tax on the transfer of the business to the company.

If you are thinking of incorporating your business, please talk to us first, as there are lots of details to hammer out which will be specific to your business.

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