If you work for yourself, you have a couple of options of trading entity, e.g. as a:
- Sole trader (an individual)
- Partnership (two or more individuals or companies)
- Limited liability partnership
- Limited company
We are often asked, ‘Should I form a limited company?’ The reality is that there is no easy answer, as each situation has to be judged individually. As well as the obvious issues of tax and national insurance contributions (NIC), there are many other potentially relevant factors, such as:
- The business
- Its expected rate of growth
- The degree of commercial risk
- Administrative obligations
- Personal preferences
In the early years of a business, the privacy of operating as a sole trader or partnership may be attractive, as well as the ease with which it can be set up. However, circumstances may change which make a limited company more relevant. A company is a completely separate legal entity subject to two main areas of regulation – tax and company law. It can sue and be sued. The following guide weighs up some of the advantages and disadvantages of trading as a limited company.
Possible advantages of incorporation
Incorporation normally provides limited liability. If a shareholder has paid fully for his or her shares, he or she cannot normally be required to invest any more in the company. Although companies with bank borrowings often have to provide directors’ personal guarantees, the protection of limited liability will generally apply in respect of liabilities to other creditors.
Effective ownership or part ownership of the business may be readily transferred, subject to the provisions of the Articles of Association. Whilst such transfers may well be covered by inheritance tax business property relief, the capital gains tax position may need careful review.
Normally a bank can take extra security by means of a ‘floating charge’ over the assets of the company, which will increase the amount that can be borrowed compared with a sole trader or partnership.
Shareholders can be paid in dividends (currently free of NIC), subject to company law formalities.
The National Minimum Wage (NMW) does not apply to directors (as they are office holders) unless they have a contract of employment.
Growing businesses can re-invest profits after an overall tax charge of 20% (if profits are below £300,000), compared with 42% for higher-rate tax paying sole traders and partners.
Corporate status often adds to the credibility or commercial respectability of the business.
Possible disadvantages of incorporation
Formation of a company incurs legal and administrative costs, which may include new accounting records and possibly systems, new PAYE system, new business tax reference, new VAT registration, new stationery etc.
Customers, suppliers and service providers must be informed of a change to limited company status.
The tax position arising on the incorporation of an existing business needs careful analysis, notably in respect of capital gains tax.
Annual accounts must comply with the requirements of the Companies Act. However, most small companies are spared the cost of having a statutory audit (which involves work over and above that which is normally carried out for a sole trader or partnership).
A company’s accounts must be filed on public view with the Registrar of Companies (although for small companies, the accounts are usually abbreviated).
An annual return must also be submitted to the Registrar of Companies together with a filing fee of £40 (£13 if filed online).
A company must also file a corporation tax return.
Funds withdrawn from a company may give rise to tax liabilities, whereas owners of unincorporated businesses can generally introduce and withdraw cash without tax implications.
Remuneration for directors is subject to both employee’s and employer’s NIC – currently up to 25.8%. Both the company and its directors are liable to NIC on many benefits in kind, and a form P11D may need to be prepared for each director, whatever the level of earnings. This can subsequently lead to extra work in filing a tax return.
Tax on directors’ remuneration paid monthly is payable on the 19th of the following month (22nd for electronic payment) through the PAYE system, and corporation tax is payable nine months after the end of a company’s accounting period. For a sole trader or partnership, tax is generally paid by instalments on 31 January and 31 July on the current year basis. The ‘credit period’ depends upon the choice of accounting date.
The ‘IR35’ legislation relating to personal service companies could be relevant, especially for service providers who work for only one customer.
Companies pay tax on capital gains at their corporation tax rate (20% for profits up to £300,000). In a company, a capital gain is reflected in the value of its shares and if these are sold a “double charge” to capital gains tax can arise. This may be avoided if assets that are likely to increase in value are owned either outside the company, or if a company is sold complete with its assets.
An individual has greater flexibility in dealing with trading losses.
A company director is more at risk of criminal or civil penalty proceedings, e.g. for late filing of accounts or for breaching the insolvency rules.
As you can appreciate, there is no easy option, but hopefully the issues above will have given you an idea of what would be involved.