Which is best for you?
Many businesses begin life as a sole trader, it’s just how most people start out, and you may have heard that you can save tax by running your business through a limited company. With more personal responsibility on you as a sole trader when it comes to factors such as losses and tax, changing to a limited company structure (also known as “incorporation”) might be the best option for you as your business grows, however there are advantages and disadvantages of doing this. We’ll look at those shortly, but first up there are two options to consider when you want to incorporate your business:
Option 1 – Incorporation Relief
This is the default position of any individual incorporating a sole trader business to a limited company. In this option, incorporation relief delays paying capital gains tax (CGT) if you transfer your sole trader business to a limited company in return for shares, rather than cash. This means that any CGT charge on the whole, or part of the gain is postponed until you exit the limited company.
Option 2 – Capital Gains Tax
Alternatively, the sole trader can decide against applying incorporation relief and pay CGT upfront. The little-known benefit of paying CGT immediately is that a Director’s loan account (DLA) worth the value of your sole trader business can be drawn down from the limited company, completely tax-free. You would need a Business valuation prior to going down this route, and this is a tricky process for any business owner to do. The value is calculated based on its tangible and intangible assets. Get in touch with On The Spot to talk about getting an accurate valuation of your business.
Now, let’s look into the Advantages and Disadvantages in detail:
Advantages of Incorporation
This is one of the key advantages. If you are making profit of more than £40,000 a year, you are more likely to be tax efficient as a limited company rather than a sole trader. The business can pay you salary and dividends, resulting in less tax! Let’s break this down using an example based on a salary of £8,400 and a dividend of £24,000:
As your salary falls within the personal allowance, there is no income tax to pay. In addition, because you’re earning less than £162 a week, you won’t pay national insurance either.
You’ll also be able to add the £3,450 of your unused personal allowance to your £2,000 dividend allowance, meaning you take £5,450 of your dividend tax-free.
The remaining £18,550 is taxed at 7.5% giving a tax charge of £1,391, meaning you take home £31,009 of your £32,400 earnings. Even taking the £7,600 of corporation tax paid by the Company on the profits into account, it still works out much better than what a sole trader would take home.
Being a limited company can also offers more flexibility with regards to expenses. If you travel or eat out while on business, you would be able to claim some or all of this expenditure. You can also buy equipment you need through your business to further increase its profitability.
Limited Liability Protection
Because a limited company is a separate legal entity from its directors, the company can own equipment, incur debts and pay bills in its own right. That means that, in most instances, if the company is sued, your own personal assets, such as your house and car, cannot be seized to pay the debt. If you are a sole trader, on the other hand, your own assets could be seized to pay a business debt, because you and the business are legally the same entity.
Boost your Professional Status
Generally speaking, having Ltd at the end of your company name looks more professional to Customers and gives a sense of kudos. It is important to convey a sense of confidence in yourself and that will, in turn, make Customers confident in you too.
Attract Investment more easily
As a limited company, you will be able to sell shares in your business to investors, relatively easily. Sole traders cannot seek investment in the same way.
Disadvantages of Incorporation
Whilst Sole traders only have to file a tax return each year, a limited company has to file a set of statutory filleted accounts, a confirmation statement and a Corporation tax return each year.
In addition, each director must file a personal tax return to HMRC. If you are an employee of your company and take a salary, you will also have to register the company as an employer and set up a payroll scheme.
All this means that after incorporation you will either have to spend more time preparing and filing paperwork, or you will need to pay your accountant more to do this for you.
Potential Tax Costs
As the director of a limited company, you would no longer be able to draw money freely out of your business bank account. The company could pay you a salary, pay dividends on the shares you own, and reimburse you for any expenses you incur on its behalf, however, if you were to take money out of the company for any other reason, you may have to pay extra tax.
Another potential tax implication is that when a limited company makes a loss, it can only use that loss against its own profits. Sole traders, on the other hand, may be able to use any loss their business makes to save tax on their other income. For example, if a sole trader is also employed elsewhere, they may be able to use their business losses to reduce the tax they pay on their employment income.
Your legal responsibilities as company director would include safeguarding the company’s assets and making the decision to cease trading if you knew the company couldn’t survive. If you fail in your legal responsibilities as a director, the consequences can be serious: you could be fined or even go to prison.
When you file your company’s filleted accounts and confirmation statement, these documents will be in the public domain, available for anyone to see on sites such as Companies House. This means that your figures will be visible to the public, along with your company’s office address. If you didn’t want your home address visible to the public, you can seek to use your accountant’s office or pay annually for a virtual registered address.
Talk to your Accountant
So, as you can see, when it comes to deciding whether or not to incorporate your company, it’s not a straight forward decision! It’s important to discuss any potential tax savings, as the answer can be different depending on other income and an individual’s circumstances. The classic line “my mate down the pub said…” is often misguided advice. Consider your situation carefully and talk to someone like On The Spot.