Restricting tax reliefs on incorporation of law firms

Yesterday, the Chancellor surprised many by announcing changes to the tax treatment of incorporations with immediate effect.

Law firms are currently incorporating in large numbers, and there are now more law firms practising as limited companies than either partnerships or LLPs.  There are many strategic reasons behind that trend, one of which is the tax advantages of both the initial transition and the ongoing practice.

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 draw down on the 90% balance tax-free.  Effectively this provided a one-off bonus on amounts that would have been withdrawn anyway, but at a lower effective rate of tax. 

From 3 December 2014 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; or
  •  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.

The Chancellor has 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.

Although tax savings upon law firm incorporations will now be lower, 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% w.e.f. 1 April 2015). 

Strategic reasons for incorporating will continue, including:

• Limited liability
• Catalyst for cultural change
• Potential investors post Legal Services Act
• Succession planning - attracting new partners
• Mergers – attracting merger parties

The ability of unincorporated law firms to sell goodwill to their own company, and pay only 10% tax and then subsequently withdraw the money from their loan accounts tax free, was seen by many as the icing on the cake.  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.

Please contact me if you would like further detail on this change, or if you would like a review of your practice structure.

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