One of the decisions new businesses often face is whether to operate as a sole trader, partnership or limited company. Most small business owners choose the sole trader or partnership route at least to begin with, because it’s the easier option, and perhaps because incorporation is associated with larger organisations with multiple directors and investors.
Whilst it is certainly true that choosing the sole trader option is likely to be the easiest and most cost effective option to begin with, there are longer term benefits to incorporation which apply to businesses of all sizes. Furthermore, company formation is a fairly straightforward process. There need only be one or two directors/shareholders, and there are just a few statutory laws to consider.
The chief benefits of incorporation as follows:-
1. Tax savings
Precisely how much tax is saved by incorporating depends very much on how much profit the business makes and, to some extent, how much of this profit is taken as drawings by the business owner(s). For profits of £10,000 or less, your tax liability will be minimal irrespective of your legal structure, but for larger profits the savings can be significant. A sole trader paying standard rate tax will pay income tax of 20% and Class 4 NI of 9% on all profits above their personal allowance (currently just over £7,000 per year), as well as paying Class 2 NI of £2.50 per week. As a limited company, the rate of tax is 20% but with no NI payable.
For example, suppose your business makes £40,000 per year. As a sole trader you pay 20% tax on all income above the personal allowance:
(40000 – 7475) x 20% = £6505
Then there is the National Insurance:
Class 2 NI (2.50 x 52) = £130
Class 4 NI (40000 – 7225) x 9% = £2949.75
So your total tax and NI bill for the year is £9584.75 as a sole trader.
As a limited company, you can pay yourself a notional salary of £7475 per year. This uses up your personal allowance (and is therefore tax free) and reduces the company profits accordingly. The remainder is taxed at the small companies rate:
(40000 – 7475) x 20% = £6505
And that’s it – there is no personal tax or NI so you save just over £3,000 per year in tax. You also get longer to pay. Corporation tax is due 9 months after the year end, whereas income tax is payable on account in six-monthly installments in January and July each year.
For earnings of more than about £43,000 it becomes a little more complex as we are into higher rate territory but the tax savings are still significant, and for these levels of income you would want to think about incorporating anyway given the size of the organisation.
2. Limited liability
As a sole trader you are your business, so in the event of financial difficulties, your own personal assets could be at risk. A limited company is a separate legal entity which means that you are not personally liable for the debts of the company, and personal assets such as your home will not be at risk in the event of financial trouble. It’s important to note, however, that the directors do have legal obligations to ensure that the company’s finances are in good order.
Furthermore banks will often ask for a personal guarantee before try starting a new limited company lending you money, meaning that company debts may well still be secured on your own home or other personal assets.
3. Professional image
Your business may be more attractive to potential customers as a limited company, as it makes your organisation appear larger and more established.
There are a few disadvantages to incorporating:-
1. Extra laws and paperwork
As a limited company you must file an annual return and statutory accounts at Companies House each year. You must also display your company name and number on all of your stationery, website etc.
2. Higher costs
These are usually more than offset by the tax savings, but accountant’s fees are generally higher, and there is the cost of forming the company and filing an annual return each year.
3. Separate legal structure
Because the company is a separate legal entity in its own right, the transfer of money and assets in and out of the company has to be accounted for properly. Borrowing money from your own company can have severe tax implications, and transferring of property and other assets out of a company can potentially land you with a sizeable capital gains tax bill.
Nevertheless, incorporation is usually beneficial for businesses making more than about £15,000 to £20,000 profit per annum, and is a worthwhile consideration once the business is up and running and trading profitably.