The question of whether a business should incorporate or not crops up often and for small businesses, is potentially very important as there are a number of tax and regulatory considerations which need to be taken into account
In general terms, operating as a limited company can yield small business owners useful savings in tax, whilst incorporation also provides protections from creditors in the event of things not going well. However, there are inceased administrative and cost burdens associated with running limited companies and it is for this reason that not all small busineses choose to incorporate. As. rule of thumb, businesses with sales of less than £35k are unlikely to see much financial benefit from incorporating (although the benefit of limited liability is still available and real) whilst for businesses with sales of more than £55k, incorporation is probably a good idea.
What are the key differences between a sole trade and a limited company ?
When a business is run as a sole trade, the business and its owner are treated as one and the same by both the taxation system and by the legal system. This means in practice that any profits made by the business are taxed against the owner directly and are subject to Income Tax through the Self Assessment system. It also means that the owner assumes personal responsibiity for the business’ liabilities and in the event that things go wrong, could result in an owner being pursued by his or her creditors.
A limited company on the other hand is incorporated as a separate legal entity from its owners – literally a separate legal person. An important consequence of this is that unlike in a sole trade, a company’s money does not belong to the owner (it belongs to the company) and an owner cannot therefore just take money from a company’s bank account in the same way as they can from a sole trade’s account. From a taxation point of view, a company’s profits are liable to Corporation Tax (not income tax) which operates on quite different rules (and rates) to Income Tax. Likewise, from a legal point of view, in the event that things do go wrong, the owners liability for the debts of the company is limited to the share capital of the business (usually a nominal sum) and no more.
Advantages of Incorporating your business
Some of the main advantages of running a limited company are as follows :-
- Personal liability for the owners (shareholders) is minimised and usually is limited to their investment in the company’s shares and no more
- Incorporating as a limited company can provides a more professional status to your business. Indeed, some businesses will not deal with sole trades
- Operating a limited company can be a more tax efficient way of running a business compared to other setups. Although recent changes in the rates of Corporation Tax have altered the balance slightly, most small businesses will still pay Corporation Tax of around 19% or just a little more. In the hands of the owner, these profits if taken as dividends will be taxed at 7.5% (if they fall within the basic tax band – 32.5% is they fall into the higher tax band) with no National Insurance to pay. Furthermore, the first £2,000 of dividends can be received free of any tax. Those same profits in a sole trade will be taxed at 20% IncomeTax plus a further 11.5% National Insurance.
- Another great and sometimes overlooked advantage of a limited company is that owners have much more flexibility in remunerating themselves and planning their finances which are not available in other structures. So for example, they can choose to keep theor profits in a company and not take them as either salaries or dividends (and not pay tax on them )should they choose. Sole traders do not have this choice and all profits of the business are subject to Income Tax in the year they arise.
- Companies can have multiple owners, thereby increasing the lending and investment opportunities open to business owners. When a sole trade acquires multiple owners, it becomes a partnership which can introduce complications.
- Because a limited company is separated from its owners, a businesses can be easier to pass on to other people if it is incoroprated. This can help with succession/retirement planning in the future. A sole trade on the other hand ceases when the sole trader stops trading.
Disadvantages of Incorporating
So what are the arguments against incorporating ? Some of the key points to consider are as follows :-
- There is a little bit more formality and administration involved in setting up and running a limited company. Comapnies for example are required to minute certain decisions (such as the approval and payment of dividends) and to report other key changes to Companies House (such as the appointment or removal of directors)
- The accounting and reporting requirements for a limited company are a little more complex and will usually require an accountant to help manage them. This is because a Company must file its accounts at Companies House and there are strict requirements around the format and content of company accounts. Sole trades are not subject to the same kinds of rules.
- Moving money in and out of the company must be done in accordance with strict rules – the company’s money is separate from that of its owners and must therefore be formally paid out by it – either through a payroll, as a loan or s a dividend. In addition, some transactions between a company and its owners/directors can have tax implications which need careful management.
- Company registers must be maintained and made available for inspection at your registered office
- Aspects of a company’s business are publicly disclosed at Companies House – strict confidentiality is not therefore always possible in all matters.
- Companies usually cost more to setup and run
There are good sensible reasons for operating either kind of business structure and there are no absolute right and wrong answers here. In general however, we would advise businesses to incorporate once they get past a certain size as the tax advantages will outweigh the costs