Should you incorporate your business?

1st March 2017

limited2Deciding under which structure your business should operate is crucial, whether that be in terms of tax savings, perception to the outside world, keeping things simple or any future plans you may have. You may be a sole trader currently contemplating whether to “go limited” and would like to consider the key advantages and disadvantages of trading as a self-employed sole trader vs. a Limited Company.

In this article, we review the key differences between trading as a sole trader or a Limited Company in terms of the tax consequences, administrative requirements and other non-financial aspects in respect of the 2016/17 tax year. Issues such as the recent major change to how company dividends are taxed are key examples of the areas that need to be considered before taking the plunge.

Tax Implications

Due to the changes in dividend taxation from 2016/17 there has been, in some cases, a reduction in the tax advantages that trading as a Limited Company offers over a sole trader.

As a sole trader an individual must pay tax on all profits over and above their personal allowance, which, for most tax-payers, is £11,000 for the 2016/17 tax year. Once that personal allowance threshold is reached, then tax must be paid at the basic rate of 20% up to £43,000, then 40% (higher rate) between £43,000 and £149,999 and then 45% (additional rate) over £150,000 income. As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4.

As a Limited Company, Corporation Tax is paid by the business on profits at a current rate of 20%. In addition to this there can be Personal Tax to be paid with regard to remuneration from the business by the owner/Director.

In order for the extractions to be as tax efficient as possible, the Director normally would draw a small salary from the company within their personal allowance but not above the point where National Insurance must be paid. This salary would then class as an allowable business cost, so Corporation Tax at 20% would not be paid on this amount – meaning 20% is saved on the salary.

The remainder of the owner’s/Director’s withdrawals would usually be in the form of dividends, which are paid out of post-tax profits and are not deductible expenses for Corporation Tax purposes so offer no tax saving, however there is no National Insurance to pay on dividends. The first £5,000 of dividends also currently falls within a 0% tax band.

For all dividends over and above this £5,000 0% tax band, the rates of tax are then as follows:

– 7.5% at the basic rate of tax
– 32.5% at the higher rate of tax
– 38.1% at the additional rate of tax

There is no requirement for the owner to withdraw all profits from the business if they are not personally needed, and it can prove tax-efficient to leave profits retained in the company for extraction at a later date or to re-invest in the company.

How does this apply in practice?

Whether it is more tax-efficient to operate as a sole trader or a Limited Company depends on the individual circumstances of the business. We have taken different scenarios below to show how tax liabilities may differ dependent on the particular business situation.

Tax differences of a sole trader vs. Limited Company for 2016/17:

Profits £000’s Total Tax and NI Sole Trader £000’s Total Tax Limited Co. £000’s Savings as Limited £000’s
20 3 2.5 0.5
25 4.5 3.8 0.7
30 5.9 5.1 0.8
35 7.4 6.4 1.0
40 8.8 7.7 1.1
45 10.5 9.0 1.5
50 12.6 10.3 2.3
55 14.7 12.3 2.5
60 16.8 14.6 2.3
65 18.9 16.9 2.1
70 21 19.2 1.9
75 23.1 21.5 1.7
80 25.2 23.8 1.5

*Some notes about our calculations

Our tax comparisons assume a simple position where the only income being earned by a person is either their sole trader income or their salary and dividends from their Limited Company i.e. there is no other personal income to consider such as rental income. We have assumed an optimum level of salary and dividends in the scenario of a Limited Company and the figures include National Insurance payable as a sole trader. The profits are on a like-for-like basis so do not include salary for the Limited Company.

We can see from the table above that, in the instance where all profits are withdrawn from the Limited Company, the savings do not continue to increase as profits rise past £60,000. The optimum level in this scenario is approx. £52,000.

The important thing to note is that, although these scenarios do show savings at all levels of profitability as a Limited Company, the additional administration costs when incorporating could well exceed the tax benefits, especially at the lower levels.

KEY AREAS TO CONSIDER BEFORE INCORPORATING

 

Do you need to draw all of your profits as income?

The main question to ask yourself is, “Do you need to take all of the profits from the business as income?” If you can afford to leave a proportion of your post-tax profits in the business, then it may well prove beneficial to incorporate. This is why:

Regardless of how much you draw out of the business, as a sole trader you are taxed on the profits. So, if you had taken £30,000 as drawings in a single tax year, but your profits were £60,000, then you would pay tax and NI on the £60,000, placing you in the higher rate tax payer threshold. In this instance, you would pay tax and NI of £16.8k.

However, as a Limited Company, you have the option to leave post-tax profits within the company and not withdraw them. Perhaps, for example, you may wish to invest in new equipment or staff further down the line. So, in this instance, say you again had profits of £60,000 and had taken £40k in salary and dividends, but left £20k within the business, then your combined corporation tax and personal tax would total £11.4k, giving a tax saving of £5.4k when compared to being a sole trader. The difference is so large because the sole trader is in the higher tax band and paying 40% of any profits above £43k whether they had drawn all of that cash or not.

 Which Expenses will you be claiming for?

When a Director of a Limited Company, you are classed as an employee, and therefore entitled to a range of tax-free benefits, the most obvious of which are mobile phones and cars. As long as there is significant business use, then in some circumstances these items can be provided tax-free e.g. pool cars. In the instance of a sole trader, you would need to declare and differentiate private vs. business use proportions and reduce the amount you claim for accordingly.

Pension contributions are one area where tax benefits can be greater as a Director of a Limited Company as opposed to a sole trader. Tax relief on pension payments as a sole trader can be quite restrictive compared to the relief possible as a Director and there are additional corporate tax benefits to a Limited Company, as company pension contributions will usually also be an allowable cost for corporation tax purposes.

*Always discuss pensions with a pensions advisor before making any decisions. Our sister company, Key Wealth Management provides professional and personalised investment advice, including pensions.

Do your benefits outweigh the additional administration?

It goes without saying that the administration required as a Limited Company is considerably more than that of a sole trader.
As a sole trader, you typically would not need to do more than file a self-assessment tax return and pay any tax due by 31 January (and possibly 31 July) following the end of the tax year.

As a Limited Company, you will need to:

  • Register your company with Companies House, ensuring that you pick a legal and suitable name.
  • Select and appoint your Directors and shareholders. In general, the two appointments are usually held by one and the same people, but you should understand the difference between the two and the associated entitlements.
  • Make your business affairs public. As a Limited Company, you are required to maintain full and accurate accounting records, prepare and file annual accounts with Companies House, file an annual confirmation statement and ensure that your company complies with relevant tax and employment law.

All of these additional administration requirements will accrue additional costs, and you will generally need the assistance of a professional accountant.

 Are there other benefits for you as a Limited Company?

Limited Liability Status

The most obvious benefit as a Limited Company is its limited liability status. Essentially, this gives a safety net to the individual shareholders of a company that, should the company become insolvent, then creditors are only able to sue the company, not the individual shareholders themselves.

For a sole trader there is no such distinction between personal and business assets as the business and the individual have no separate legal status. Therefore personal assets such as the family home could be at risk, certainly where the business operates in a fairly litigious or highly sensitive sector.

An enhanced public image

Limited Companies are often viewed as more established and a safer option by potential customers and business stakeholders. By acquiring Limited status, you can enhance the reputation of your business and give you a sense of credibility that sometimes does not come with being a sole trader. In some instances, potential customers may have a policy that they will only work with Limited Companies. 

Summary

We hope that, from our article, you can see that there are many issues to consider when choosing between operating as a sole trader or a Limited Company.

Overall, there are distinct security and tax advantages of operating as a Limited Company at certain profitability levels, however every business is different and individual circumstances and scenarios need to be considered carefully.

A one-size fits all approach is not suitable, particularly given the recent changes to the taxation of dividends.

Making the decision to incorporate is a large step and you should seek the advice of an experienced and qualified accountant. At TTR Barnes, we are here to help you assess your personal circumstances, and understand which option is the best for you.

If you would like to discuss whether incorporating is the right choice for your business, please do not hesitate to contact one of our Directors, we can help you consider the options and implications for your individual circumstances.

David Cook david.cook@ttrbarnes.com 0191 567 0304

david cook ttr barnes

 

 

 

Allan Russell allan.russell@ttrbarnes.com 0191 567 0304

allan russell

 

All information correct at time of publication February 2017.

Chartered Accountants in Sunderland, offering expertise on everything from Tax and Business Planning,
to Accounts and VAT.