Business owners are often unsure about which entity to trade as - sole trade, partnership or limited company.
Regardless of size, ownership structure, industry etc, generally there is no legal obligation to trade using a particular entity, but there are stark differences between them. And it is the impact of these differences that must be evaluated in order to decide which entity to trade as.
In this article, we review the advantages and disadvantages of trading via a limited company, and reflect on the recent changes to the UK income tax and National Insurance rates.
The Advantages of Incorporation
Seeing ‘limited’ at the end of a business’ name gives the business some prestige and gives an illusion that the business is large.
Whilst the company remains on Companies House register, no other company can be formed with the same name, and you may even be able to get other later formed companies to alter their name if it is too similar to the one you have chosen.
Investors prefer to put their money into a company rather than a sole trade or partnership because if they purchase shares, their investment has more protection and their liability is limited to their shareholding (should the company run into difficulties and fold). Therefore limited companies can offer investors more security.
Banks tend to prefer dealing with companies, again for similar reasons to individual investors. Furthermore, they are able to taking out extra security by lodging a ‘floating charge’ over the assets of the company. The charge effectively means the bank gets first call on the assets stated in the charge should the terms and conditions of the loan be breached etc.
The Succession of Shareholders
Transferring shares in a limited company is more straightforward to deal with than it would be to say, transfer a partner’s share in a partnership. The main obstacle would be if there was an unusual restriction in the company’s articles or a shareholders’ agreement.
Some expenses that would naturally be disallowed in an unincorporated entity can attract tax relief in a limited company. Subject to certain conditions, examples of these include training expenses and pension contributions.
Effective Rates of Tax
The remuneration package for director-shareholders of small companies tends to consist of a small salary (large enough to ensure that they earn a qualifying year for state benefit purposes) and dividends. Dividends are favourable because they attract no National Insurance and they are taxed at a lower rate of income tax than self employment income.
The examples below give an indication of the 2012/13 tax savings that may be achievable for husband and wife who are currently in partnership:
|Tax & NI payable as a:|
The extent of the savings is dependent on the precise circumstances of the couple’s tax position and may be more or less than the above figures. The examples are computed on the basis that the couple:
• share profits equally
• have no other sources of income
• both partners take a salary of £7,488 from the company with the balance (after corporation tax) paid out as a dividend
Taxed on Withdrawals
Proprietors of unincorporated entities are taxed on their share of the business’ profits; regardless of what they actually withdrew. Companies are also taxed, but the rate of tax they pay under the current UK tax regime is lower than individuals do, plus they pay no National Insurance on their profits. Therefore, incorporation might be appealing if the intention is to retain some of the profits within the business.
The Disadvantages of Incorporation
Directors and shareholders of the company may have to complete tax returns, and the company has its own filing requirements. It must submit its own tax return and annual accounts, and an Annual Return. If the directors are being paid a salary the company may also need to set up an Employers’ scheme and therefore complete an employer’s Annual Return.
Directors have a personal responsibility to delivery statutory documents to Companies House and failure to do so can be a criminal offence, in addition to late filing penalties.
Whilst there is a perception that finance may be easier to obtain by companies, it is worth noting that it is common for banks to ask for personal guarantees from the directors (particularly in newly formed companies), which means the directors can still be liable for the company’s debts.
The company’s details and accounts are held on public record and can therefore be accessed by anyone. Furthermore, information about the company’s directors, company secretary and shareholders can be accessed- although it can be limited.
Due to the level of reporting requirements, accountancy fees for companies are often higher than they would be for an unincorporated entity.
Separate Legal Entity
With an unincorporated business, the owners are free to make withdrawals without tax implications. However, the same is not true in a company situation and directors and/ or shareholders can often struggle to draw a distinction between the company and their own affairs.
An unincorporated business holding assets with mixed-use or making expenditure for both private and personal purposes is pretty straightforward to deal with in terms of the tax treatment and disclosure. However, such items in a limited company can lead to tax charges, Employer’s National Insurance and additional reporting requirements.
Losses made by a sole trader or partner are far more malleable than if they had been generated by a company, and can for example be carried back (potentially up to three years in new trades), carried forward or offset against capital gains made by the proprietor. Losses made a company can only be utilised by the company.
By Jo Nockels
Last updated May 2012
Disclaimer: The information provided is based on current guidance (at date of publication) from HMRC and may be subject to change. Any advice shared here is intended to inform rather than advise. Taxpayer's circumstances do vary and if you feel that the information provided is beneficial it is important that you contact us before implementation. If you take, or do not take action as a result of reading this information, before receiving our written endorsement, we will accept no responsibility for any financial loss incurred.