This is a common question I am asked by business owners all the time. Here’s some pros and cons:
Many small businesses operate as sole traders or partnerships – but many accountants do at times encourage their unincorporated clients to incorporate as a limited company. This means that you’re still running the same business but, as director, you’re an employee of the limited company that now owns the business.
Maybe you find it hard to see what the difference is in practice – but there are some significant advantages.
Successive budgets have, I’m afraid, eroded some of the advantages that used to exist and I’ll just cover these first.
- Entrepreneurs’ Relief (‘ER’) on incorporation – when you transfer the goodwill and assets from yourself as sole trader to a limited company, this is a disposal for Capital Gains Tax. ER meant that any CGT was reduced to 10% and the limited company then had the acquisition value (for any future CGT) as at the date of incorporation. Now, although you get relief from CGT on the transfer, you don’t get that uplift in value for future disposals for CGT. Keep an eye out for my blog on ‘What You Can Claim – ER’ for more details.
- Dividends – it was usually more tax-efficient to run as a limited company and take money as a small salary plus dividends, rather than, as a sole trader/partnership, having the whole of the annual profit treated as your income and taxed at your personal rate.
- From 6 April 2016, the first £5,000 of dividend income in each tax year will be tax-free. Previously, when a dividend was declared a tax credit certificate was issued equivalent to income tax at the basic rate, which meant that effectively basic-rate taxpayers paid no tax on the dividend income in their hands. From 6 April 2016, no tax credit is issued, so dividend income is declared by the recipient on the personal annual self-assessment tax return to be taxed as personal income. Whether or not this means you pay more tax than you would have done under the previous system depends entirely on how much taxable income you have. From April 2018, the dividend allowance will be reduced from £5,000 to £2,000.
- Company loans – it’s a common device for directors or participators in small companies to have a loan, in one form or another, from the company. This could occur where directors have drawn against anticipated trading profits which do not reach the expected level, resulting in an overdrawn director’s loan account. Alternatively a company might have a planned strategy of making loans to shareholders (which may never be repaid). However it arises, a loan to a participator is a benefit which is taxable on the company.
But from 6 April 2016 the rate of tax on such loans (paid by the company) rose from 25% to 32.5% so this will, of course, deplete the level of surplus money in the company. Also, if the loan is interest-free, over £10,000 and made to a director, then it will be treated as an employment-related loan and the individual will suffer not only tax but NI (and the company will pay employer’s Class 1A NI). This can also apply to loans which indirectly benefit a director.
So, that’s the downside, but I firmly believe there is still a lot of mileage in sole traders/partnerships running as a limited company.
Taxation Advantages that still apply
- A business with an annual profit of £30,000 will pay £800 less tax as a limited company. If the profits rise to £50,000 profit it will pay £2,310 less tax. This includes taking into account the NIC paid by a sole trader business (companies don’t pay NIC).
- With a limited company, you don’t need to adjust your accounts for private expenses for use of assets (although you will still need to keep track of these to account for them being a personal taxable benefit).
- A VAT Scheme for a limited company operates completely independently of any other business you run as an individual (or through another limited company).
- Flexibility in the way you extract profits from the company, so that you can maximise the tax-efficiency. This can include a tax-free loan to you as a director of up to £10,000 (but see above for taxation on company).
- As a director, you are technically an employee of the company. This makes you eligible for a for a whole range of tax-free benefits that are not available to you as a self-employed sole trader.
The limited company (unlike a sole trader business) is a separate legal entity and so:
- In principle, your personal assets are not liable for the company’s debts (unless you have given a legal charge or a personal guarantee, or go on trading whilst insolvent).
- The company’s activities are completely separate from any other business or employment, so if the company makes a loss it doesn’t affect these
- If your company fails you don’t risk personal bankruptcy
- You can give others a share in the company without relinquishing control, and you have more flexibility in passing on the business.
- You can get ER by selling your shares in the company without necessarily retiring
- In many sectors, operating as a limited company gives you more status than operating as a sole trader
It’s true that there are a few more regulations to cope with in accounts preparation and compliance with Companies House – but your accountant should see to that!
Do have a look at my forthcoming series of blogs on ‘What You Can Claim’ and you’ll see that these mostly refer to limited companies – because I still think that’s the way to go. Do let me know what you think!