Incorporation: Considering the Pros and Cons
There are many factors to consider when deciding to operate as a sole trader or limited company, including the tax implications for each entity.
Limited companies are charged corporation tax on their profits but there is also a possible second tax on dividends to shareholders and directors.
In comparison sole traders and partnerships are only obliged to pay income tax on their profits.
Despite this, more people may be tempted to incorporate their business following announcements made in the recent Emergency Budget which will see corporation tax for small businesses reduced from 21 per cent to 20 per cent from April 2011.
Incorporated businesses also enjoy limited liability status, meaning that, as a separate legal entity in its own right, personal assets of the directors and shareholders are protected from creditors if they run into financial difficulties, which is not the case for sole traders who face much greater risk.
The downside of this is that limited companies are subject to much more stringent financial checks.
While sole traders need only fill out their annual tax returns, limited companies must keep detailed accounting records, file accounts and an annual return with the Registrar of Companies and keep statutory books.
There is also a further consideration to make with regard to recently announced proposals from the Government, which suggest that significant revisions will be made to the UK pensions system. The changes may prompt some to set up limited companies.
One of the key changes is the plan to vastly reduce the annual allowance qualifying for tax relief, from £255,000 to between £30,000 and £45,000 a year.
The impact of this is that more self-employed people will have to pay extra tax if they want to make a large contribution to their pension pot.
In a recent article for BBC News, finance expert Ronnie Ludwig explained that one possible solution to this is for sole traders to incorporate their business. This is because, as a sole trader, their earnings for pension purposes are the same as the profits stated in their annual accounts.
Therefore, it is often necessary for them to pay greater amounts into their pensions when they have a good financial year to compensate for leaner times, but under the new proposals doing so could result in hefty tax bills.
But if they became a limited company, pension contributions would be calculated on the salary they pay themselves and not on the profitability of the business.
However, while this may be one benefit of incorporating a business, there are many factors that need to be considered when deciding to operate as a sole trader or a limited company.
One such factor is National Insurance Contributions with limited companies having to make greater contributions overall than sole traders.
This could become even more of a disadvantage thanks to another new pension proposal which may see the outlawing of transferring final salary pensions into defined pension contributions schemes.
The change would mean that many employers and employees would have to make bigger national insurance contributions, as currently workers receive a 1.6 per cent discount on national insurance, while their employers receive a 3.7 per cent discount.
With such an array of pros and cons to consider when it comes to deciding whether or not to go from being a sole trader to an incorporated business, many may want to seek out specialist advice from a tax accountant to help make the correct decision.
How we can help
Choosing the right business entity is not always an easy decision. We would be happy to discuss your individual circumstances with you and provide you with the information you need to decide on the best way forward for your enterprise.
Call us today to speak with your local TaxAssist Accountant.
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