Tax changes have made it even more important to consider carefully, when running a business, whether it is best to trade as:
- Sole trader - an individual
- Partnership - two or more individuals or companies
- Limited liability partnership
- Limited company
We are often asked, 'Should I form a limited company?' The reality is that there is no easy answer. Each situation has to be judged individually. As well as the obvious issues of tax and national insurance contributions (NICs), there are many other potentially relevant factors, such as:
- The business
- Its expected rate of growth
- The profitability of the business
- The likely profit trend
- The degree of commercial risk
- Administrative obligations
- Personal preferences
- Pensions and retirement
In the early years of a business, the privacy and fewer administrative obligations of operating as a sole trader or partnership may be attractive. Business funds can be used with fewer restrictions than in an incorporated environment.
However, we are considering here the consequences of incorporating or not. A company is a completely separate legal entity subject to two main areas of regulation - tax and company law. This guide looks at some of the advantages and disadvantages of trading as a limited company. It is important to discuss your specific situation with us.
Possible advantages of incorporation
- Incorporation normally provides limited liability. If a shareholder has paid fully for his or her shares, he or she cannot normally be required to invest any more in the company. Although companies with bank borrowings often have to provide directors' personal guarantees, the protection of limited liability will generally apply in respect of liabilities to other creditors.
- A company enjoys legal continuity - it can own property, sue and be sued.
- Effective ownership or part ownership of the business may be readily transferred. Whilst such transfers may well be covered by inheritance tax business property relief, the capital gains tax position needs careful review.
- On occasions, a bank can take extra security by means of a charge over the assets of the company, and this will increase the amount that can be borrowed compared with a sole trader or partnership.
- External investors may be entitled to the tax breaks available through investing in the company using the Enterprise Investment Scheme or the Seed Enterprise Investment Scheme.
- Shareholders can be paid in dividends (currently free of NICs) but strict company law formalities must be observed.
- The national minimum wage and national living wage regulations do not apply to directors (as they are office holders) unless they have a statement of terms and conditions of employment.
- Growing businesses can reinvest profits after a corporation tax charge of 19% compared with 40% (41% in Scotland) for higher rate or 45% (46% in Scotland) for additional rate tax paying sole traders and partners together with a 2% class 4 national insurance charge on profits over £46,350.
- Accumulated funds could be withdrawn on a sale of shares with the benefit of capital gains tax (CGT) entrepreneurs' relief whereby business gains are taxed at 10% on the first £10,000,000 of capital gain. Thereafter any gain over the level of the relief is taxable at 20%.
- Corporate status is sometimes thought to add to the credibility or commercial respectability of the business.
- A company can establish a registered pension scheme, which may provide greater benefits than self-employed schemes.
- A company can incentivise staff through tax advantaged share options issued under the Enterprise Management Incentives scheme.
- Employees may, with adequate safeguards, be offered an opportunity to buy their own stake in the business, reflecting their commitment and importance to the company.
- The liability of executors acting for deceased shareholders, or of trustees, is clearly defined.
Potential disadvantages of incorporation
- Formation of a company incurs legal and administrative costs, which may include new accounting records and possibly systems, new PAYE system, new business tax reference, new VAT registration, requirement to file a corporation tax return, new stationery etc.
- Customers, suppliers and service providers must be informed of a change to limited company status.
- The tax position arising on the incorporation of an existing business needs careful analysis. It may be possible to defer capitals gains tax on the transfer of goodwill etc, but the timing and effect of cessation on income tax must be closely planned.
Annual accounts must comply with the requirements of the Companies Act. In most cases, a statutory audit is not required for companies if the company satisfies at least two of the following criteria:
- an annual turnover of £10.2 million or less
- assets worth no more than £5.1 million
- 50 or fewer employees on average
- The statutory audit involves work over and above that which is normally carried out for a sole trader or partnership.
- A company's accounts must be filed on public view with the Registrar of Companies. An annual confirmation statement (CS01) must also be completed online for the Registrar of Companies. The fee is £13. There is a severe penalty regime in force for failure to file on time.
- The company will be taxed on its profits of each accounting period, as opposed to the income tax 'current year' basis for sole traders and partnerships. A company must file a corporation tax return.
- Funds withdrawn from a company normally give rise to tax liabilities, whereas owners of unincorporated businesses can generally introduce and withdraw cash without tax implications.
- Remuneration for directors is subject to both employee's and employer's National Insurance liabilities - currently up to 25.8%. For example on a remuneration of £30,000 there may be a NI liability of up to £5,566.61. Both the company and its directors are liable to NIC on many benefits in kind, and a form P11D must be prepared for each director, whatever the level of earnings. This can lead to extra work in filing a tax claim for reimbursed expenses etc for which individual tax relief is available.
- Tax on directors' remuneration paid monthly is payable on the 19th of the following month (22nd for electronic payment) through the PAYE system, and corporation tax is payable nine months after the end of a company's accounting period. For a sole trader or partnership, tax is generally paid by instalments on 31 January and 31 July on the current year basis. The 'credit period' depends upon the choice of accounting date, and you should contact us for further advice on this.
- The 'IR35' legislation relating to personal service companies could be relevant, especially for IT contractors and other service providers who work for only one customer.
- Companies pay tax on capital gains at their corporation tax rate. In a company, a capital gain is reflected in the value of its shares and if these are sold a 'double charge' to capital gains tax can arise. This may be avoided if assets that are likely to increase in value are owned either outside the company or within a self-administered pension scheme, or if a company is sold complete with its assets
- An individual has greater flexibility in dealing with trading losses, particularly in the important early years of the business.
- A company director is more at risk of criminal or civil penalty proceedings, e.g. for late filing of accounts or for breaching the insolvency rules.
Is it beneficial for you to trade through a limited company? Please contact us - we are here to help you through what can sometimes be a maze of options to ensure that you fully understand your options and consequences that are relevant to your situation. There can be no substitute for a detailed analysis, and we are happy to help you in any way we can.
Do call us if you would like further help or advice on this subject.