Deciding to go into business is a big decision, but before you start it is important to decide how you will actually trade.
The introduction of a new dividend tax system has narrowed the perceived tax advantage from operating as a company compared to a sole trader. There can still be an advantage however, particularly if you do not wish to extract all of the profits from the business every year.
Deciding whether to incorporate – to set up as a limited company – should be based on whether it is right for your business, not just on the potential tax savings.
The advantage of incorporation is that it enables more flexibility. If looking to expand the business, as well as considering borrowing, a limited company provides the additional option of raising capital by selling shares to outside investors (like ‘Dragons Den’).
The ownership of a business can be divided between multiple shareholders and the ratio of ownership between individuals can be established by varying the number of shares each person holds. The ownership can be made even more complicated by having different classes of shares with different rights.
This might be a consideration in succession planning, but it is a complex area covering a number of different taxes and requires detailed analysis.
Incorporation provides a separate legal entity. As a sole trader, any liability of the business is your own liability, meaning personal assets such as the family home could be at risk.
With a limited company, the liability stays with the company and the shareholders are only liable up to the amount of their capital investment.
Trading as a limited company increases the visibility and transparency of the business. A company must file its accounts at Companies House which gives interested parties the opportunity to see who owns the business and how it is performing financially. This public ‘track record’ can be inspected by anyone, and may be a factor in securing new finance or winning new contracts.
Limited companies are taxed as separate entities. Sole traders are taxed on all of their profit each year, whereas the owner of a company can choose how much income to take from the business in salaries and dividends, giving more control over when income is taxed.
However, incorporation does bring increased compliance costs. As well as the initial set-up costs in registering the company, accounts and a confirmation statement must be filed at Companies House every year, as well as a corporation tax return to HMRC.
This is in addition to your personal tax return, which as a company director, you will still need to complete. Taking a salary from the company requires you to register a payroll with HMRC, which requires regular reporting.
The correct calculation and reporting of your corporation tax liability is another area in which you may require specialist advice. As a separate entity, the company will have to pay corporation tax on its profits, although the rate is currently significantly lower than the basic rate of income tax.
Also, you will not personally own the assets of the company. If you wish to take assets out in the future, it is likely you will have to pay corporation tax and Stamp Duty Land Tax (SDLT), and income tax if extracting cash after selling the asset.
As a director of a limited company you may have limited liability against the debts of the business, but you still have the same legal responsibilities in areas such as health and safety and public liability as a sole trader, and you can be prosecuted and fined for non-compliance.
Looking to the future, it is sometimes more costly in terms of tax to introduce new shareholders, especially if they already work for the company. If you are a sole trader, you can invite anyone to join you in business and share your combined profits, usually with no tax cost.
Incorporation can be a sensible evolution for a business, but needs to work for your overall business. There are potential tax savings, but this will depend on the type of business, profit levels, and your long term intentions. Take specialist advice early in the planning stage of your new business.
This article first appeared in Business & Innovation Magazine in January 2019.