Choosing which company format is appropriate for your business is a key decision. But it has ramifications in many areas, not least taxation, legal and administrative. So, what does each format encompass?
Sole trader – is where individual trades alone. It gives the individual complete control, but brings unlimited liability so the trader risks personal loss, even bankruptcy in extreme cases. Sole traders include an annual Self-Employment return with their self-assessment tax return. They pay Income Tax and National Insurance on their profits.
Partnership – is where two or more people run a business together. They share profits and losses and have unlimited legal liability. The rights and responsibilities of partners (including how profits and losses are shared) should be set out in a partnership agreement. Partners must complete a Partnership Tax return showing how profits and losses were divided between the partners as well as a Self-Employed tax return. Partners pay Income Tax and National Insurance on their share of the profits.
Limited company – is a legal entity in its own right. Limited companies bring added requirements such as filing annual accounts at Companies House. Companies file a Corporation Tax Return with HM Revenue and Customs (HMRC) and pay Corporation Tax on its taxable profits. Company directors are often required to file a self-assessment tax return.
Impact of taxation
Minimising your tax liability was frequently a deciding factor in forming a limited company.
However recent changes to the taxation of dividends (starting in 2016/17) making opting for limited company format less tax advantageous than previously was the case.
From 2016/17 dividends are taxed in the hands of individuals at 7.5% for basic rate taxpayers, 32.5% for higher rate (40%) taxpayers. A Dividend Tax Allowance was introduced, giving individuals a tax-free sum (£5,000 reducing to £2,000 for 2018/19 tax year). This has resulted in a significantly lower tax saving by forming a limited company (over a sole trader) of approximately £2,000 in 2017/18 on a business’ taxable profit of £75,000. The reduction in the Dividend Tax Allowance will reduce this saving by a further £975 in 2018/19.
However, if the company does not distribute all the profits as dividends it will reduce the tax on the dividends for shareholders.
There still may be tax benefits from being a limited company. If a business is sold, the shareholder can claim Entrepreneurs Relief reducing the Capital Gains Tax Rate to 10% instead of the higher and additional rate of 20%.
Another tax benefit of limited company status is cash flow on tax payments. Sole traders and partners pay Income Tax in two instalments – on 31 January in the tax year (and following 31 July) as well as making payments on account if the liability exceeds £1,000. A limited company’s Corporation Tax payment is made 9 months after the end of the accounting period.
A limited company format is essential if an entrepreneur wants to bring in outside investors.
The additional tax and accounting requirements of being a limited company can add between £500 and £1000 to the business’ costs.
Many businesses start with the simplest format of sole trader and change to limited company status when the future profitability and growth become clearer.
Many chartered accountancy firms are ICAEW Business Advice Service (BAS) members. This means that they will give a free advice session up to an hour to any business if they display the BAS logo. Do make contact to arrange a meeting to receive professional advice to help you and your business grow. After the advice session, you are free to leave without making any commitment to a continuing relationship.