8 August 2016
So, you have taken the biggest step of all and started your own business. Your product/services are ready to go but you are stuck with the inevitable question of “sole trader or limited company?”
A tax adviser’s favourite answer to any given question is ‘it depends’. Every situation is different and whilst this article is not intended to give you the answer to the million dollar question, it will certainly highlight what criteria you should look for in making a decision. As most people will be aware, the main difference between the two is that a limited company is a separate legal entity from its shareholders and so your liability is limited, however, as a sole trader there is little distinction between you and your business.
This legal separation is often the key factor in making the decision. A sole trader, as its own business, can be sued personally for business dealings (subject to suitable insurance) whilst a company benefits from it’s ‘corporate veil’ and the company will be sued (protecting personal assets). There are occasions, albeit rare, where a director can be sued personally, such as fraud cases.
N.B – If there are more than one of you (a partnership) – this is classed as a group of sole traders, therefore, the rules are the same.
So what do you need to think about?
The second most important criteria next to legal status is tax. A sole trader will pay tax on the total profits made (irrespective of drawings) and pay tax personally according to the tax bands (download our UHY tax app for the bands!). They will also pay Class 2 and 4 National Insurance Contributions (NIC) on the profits.
A company will pay Corporation Tax on taxable profits (again the rates are on our app). The employee/shareholder/director will then pay PAYE and NIC on salaries taken from the business and Income Tax only on dividends.
The tax on dividends has increased since 1 April 2016 and has led many clients to ask ‘is it still worth being a limited company?’ the answer is usually yes from a tax perspective as there are no NICs due on dividends. My general rule of thumb is, if the profits are expected to be in advance of £30,000 then a limited company tends to be more advantageous.
Any losses made by a company can only be offset against company income not against personal income. They can be carried back one year to offset against trading income, carried forward against trading Income or income in the same year.
Losses made as a sole trader can be offset against your other personal income, if you have any, and can also be carried back one year. However, in the first three years of trade there are special provisions where any losses made can be carried back against the previous three years income on a ‘first in first out’ basis.
This provision can lead someone towards a sole trade if you are expecting losses (heavy set up costs) to gain tax refunds on employment income, for example.
A sole trader does not have to prepare accounts, though it is advisable to prepare a set to work out growth and comparisons with the previous year. There are rules now for small businesses to work on a cash accounting basis rather than ‘normal rules’. On this basis admin is low as no accounts get submitted and only a Self-Assessment Tax Return is needed.
On the other hand, however, a limited company has a whole host of admin and filing duties. Annual accounts are prepared under the Companies Act and an abbreviated set sent to Companies House. HMRC also require a set in a certain format including Corporation Tax. There are accounting standards to adhere to, such as GAAP and FRS 102. As a result of this, accountancy costs (for example) tend to be higher.
If the business fails as a sole trader you are liable for it’s debts. This can lead to bankruptcy and great financial problems. Insolvency for a company is a little more complicated. The liability is limited to the amount unpaid on shares, although you need to consider whether you have signed any personal guarantees for any loans as these will likely be a personal debt.
This could be whole separate blog… Tax planning tends to be more ‘flexible’ as a limited company. Extracting funds can be via a salary, dividends, pension contributions, company cars and other benefits in kind. There are also planning arrangements with spouses and director’s loan accounts to consider. I will be writing a blog on general planning under the current landscape shortly.
Tax planning for a sole trader is not as flexible and drawings are not classed as remuneration. You are not classed as an employee of the business and a lot of expenses such as telephone or internet will be subject to private use adjustments.
The next step
I hope that this gives you food for thought. Of course, there may be other factors; such as if you are in the technology sector and carry out research and development (only limited companies can claim R&D tax credits) so, if you would like to discuss your specific circumstances, please get in touch with myself or a member of our team.