The tax benefits for law firms of incorporating have been reduced thanks to surprise changes announced by the Chancellor in this week’s Autumn Statement.
Law firms have been incorporating in large numbers, with tax advantages in both the initial transition and the ongoing practice.
There are now more law firms practising as limited companies than in any other form – sole practitioner, partnership or LLP. The most recent figures from the Solicitors Regulation Authority put the number of incorporated law firms at 3,500, or 34% of all firms.
Tax savings on the initial transition arose as a result of the limited company acquiring the goodwill from the individual owners of the prior practice.
After applying entrepreneur’s relief (ER), the owners paid capital gains tax (CGT) at 10% on that disposal and were then able to withdraw the 90% balance from their loan accounts tax-free. Effectively this provided a one-off bonus on amounts that would have been withdrawn anyway as salary or dividends, but at a lower effective rate of tax.
However, as a result of George Osborne’s announcement, ER will not be available on disposals of goodwill to a close company to which a seller is related. A close company is one that is controlled by: five or fewer participators; any number of participators if those participators are directors; or where more than half of the assets would be distributed to five or fewer participators that are directors upon winding up the business.
“It therefore catches the vast majority of law firms looking to incorporate,” said Andy Poole, legal sector partner at accountants Armstrong Watson.
The Chancellor also announced that a company will not be able to claim corporation tax (CT) relief on the amortisation of internally generated goodwill and customer-related intangible assets acquired from a related business on or after 3 December.
Tax relief on the disposal and subsequent amortisation of goodwill acquired before 3 December is unaffected.
A briefing from accountants Hazelwoods explained: “Effectively, from 3 December 2014, these two measures significantly reduce the tax benefits associated with goodwill unless there is a change of ownership, as opposed to just a change of trading entity.
“This is by no means an end to incorporation, but it does place more focus on the commercial reasons behind the decision and will change the financial modelling substantially.”
Mr Poole also said there are still good tax reasons for incorporating a business, given the current small profits CT rate of 20%, as well as a main CT rate of 20% with effect from 1 April 2015.
While the tax benefit was seen as “the icing on the cake”, he said the strategic reasons for incorporating will continue, including limited liability, a catalyst for cultural change, potential investors, succession planning and mergers.
“In future business owners will still be able to transfer goodwill to their own companies but will either have to pay full value at up to 28% CGT or, more likely, merely transfer goodwill at its base cost so as not to create a taxable gain.”