This guide provides an overview of the key issues when considering whether to run a UK trading business as an unincorporated sole trade (or if more than one person is involved, as a conventional partnership) and through a limited liability company.
The first point to make is that all factors should be considered – commercial, legal and tax. Whilst tax is important, don’t let it be the only factor you consider.
Simplicity
Many people decide to start a business as a sole trader, rather than operate through a limited company. A sole trade is a simple way to do business. Consequently, it is the most common trading vehicle in the UK.
It is straight-forward for a sole trader business to become a conventional partnership, and visa-versa. Less so for a sole trader to incorporate as a limited company, once a business is established and has become more complex. In this case, careful planning is required.
Limited liability protection – insolvency and the risk of being sued
A sole trader and his/her business are the same legal entity. You are the business. Consequently, you are personally liable for the debts of the business. If the business fails, you may go bankrupt.
The same applies to partners in a conventional partnership. Partners can form a limited liability partnership (LLP), in which case partners’ liability for business debts is limited broadly to their capital contribution.
A limited liability company is a separate legal entity to its shareholders and directors. Shareholders’ liability for a company’s debts is normally capped at the value of any unpaid share capital.
A limited company director cannot easily be sued and therefore cannot be held accountable for a company’s actions. There are exceptions to this general rule, such as cases where a director has committed fraud or corporate manslaughter. But it is very rare for a director to be held personally responsible for a company’s actions.
Protection of private assets is usually one of the key reasons for trading through a limited company. Once a business starts to employ staff and grow, the benefits of separate legal liability increase. However, be aware that lenders, landlords and suppliers can require directors of limited companies to give a personal guarantee in respect of company liabilities.
Compliance requirements – legal responsibilities
The price to pay for limited liability protection is increased compliance requirements and associated costs.
Limited companies must prepare annual accounts in a format prescribed by law. These are known as statutory accounts. These accounts must be filed at Companies House within certain time limits. These accounts are then on public record. However, small and micro companies are permitted to file simplified accounts, which allow reduced disclosure of information at Companies House.
Annual limited company accounts must also be sent to HMRC (in a prescribed i-xbrl format) with the annual corporation tax return.
Directors of limited companies have other legal responsibilities. These include filing an Annual Confirmation Statement with Companies House, maintaining a register of Persons with Significant Control and notifying Companies House of certain changes (e.g. a change in a company’s registered address, appointment/resignation of directors and changes in share capital).
The need to raise finance
Investors and lenders will usually be reluctant, even unwilling, to invest in or lend to an unincorporated business.
The share structure of a limited company also allows for fractions of shares and different classes of shares to be issued. This flexibility can facilitate investment from parties not actively involved in the business.
Business image and customer expectations
Some argue that trading as a limited company appears more impressive – making your business look bigger and more credible. Whether this is important to you will depend on the type of customers and other business contacts you deal with on a regular basis.
Taxation
Comparing the tax position of an unincorporated sole trader and a company director shareholder operating through a limited company is a complex matter. There are many factors which must be borne in mind.
It is therefore impossible to draw hard and fast conclusions, so personalised calculations must be undertaken in all cases.
However, see below for some general points to consider.
1. If you intend to keep profits in your business, a company can save you tax
This is because profits retained in a company are subject to corporation tax (CT) at a current rate of 19%.
Contrast this with the rates of tax suffered by sole traders. All the profits of a sole trader are subject to income tax and national insurance in full in the tax year they arise. So, 100% of the profits are taxed, irrespective of whether they are withdrawn or retained within the business. This means that profits exceeding the basic tax rate threshold suffer higher rates of income tax, plus NICs.
A controlling director shareholder of a company has the flexibility to choose how much profit to take from the business, in the form of salary and dividend income. It is this profit extracted or income, upon which tax is paid by the director shareholder. This means the controlling director shareholder has the option of being able to leave profit within the business, to be taxed at a CT rate (currently 19%), rather than having all profits taxed at a higher combined income tax/NI rate.
2. It is generally more tax-efficient to pay dividends rather than draw a salary
Assuming you are not caught by the Personal Service Company and Managed Service Company rules, a key tax benefit of operating through a limited company is the national insurance saving on dividend income. Dividend income is not subject to NI in the hands of the recipient, and the first £2,000 of all dividend income is free from income tax.
3. There are tax-free benefits available to company directors, which are not available to sole traders/partners
There various tax-free benefits which are available to company directors. Companies can also claim corporation tax relief for the cost of providing such tax-free benefits.
You should be careful when deciding on whether your business should pay for expensive taxable benefits (e.g. providing a car). In all cases, you need to compare the potential income tax and NI cost of a company providing such benefits, against the tax cost of using a business asset for private use as a sole trader.
4. Loss relief in early years of trading
If a new business is likely to generate losses in the first few years, it is important to consider the different tax loss relief rules available to individual sole traders and companies.
For example, if you are a sole trader and you make losses in any of the first four years of trading, you can carry back business tax losses to be relieved against any other personal income (e.g. employment income) you had in the previous three years. This is known as sideways relief. There is a cap on such relief, but it is still generous.
If a new company generates trading losses, relief usually involves losses being set against any current year other company income (e.g. investment income) or being carried forward to be set off future company profits. This means that company losses can’t be set off against other personal income.
5. Payment of tax
The cash flow impact of different tax payment dates could also be a factor in the decision whether/when to incorporate.
Any salary paid to a controlling director shareholder will be subject to PAYE income tax and Class 1 national insurance, if certain thresholds are exceeded. This will also require the running of a payroll and submission of payroll reports to HMRC.
Any corporation tax on profits retained within a company will be payable within 9 months of the accounting period-end.
Sole traders make tax payments on account (income tax and Class 4 NICs) half-yearly on 31 January in the tax year and 31 July after the tax year-end, with a final balancing payment due on 31 January after the tax year.
Pensions
As a sole trader, you can only have a personal pension.
When you incorporate, company pension schemes are available to you which may offer more benefits.
Loans to you from the business
As a sole trader, you can borrow from your business bank account – it is your account.
A company is permitted to loan money to its controlling director shareholders, but there are limits set by the Companies Act 2006. And there are potential tax costs, which must be considered.
If you would like to discuss any of the issues above, we can help. Please do get in touch for a no-obligation conversation.