Many small business owners, either at the start of trading or soon thereafter, are likely to consider whether it is beneficial to trade as a sole trader or through a limited company. Here we consider both options from the perspective of general administration, limited liability status and tax. We also look at how changes in dividend tax legislation from 6th April 2016 are likely to affect decision-making.
In many cases a business starts life as an individual being self-employed. This is the simplest of business structures requiring the business owner to prepare simple accounts which should then be reflected on a personal self-assessment tax return. For some of the smallest businesses the only detail that is required to be disclosed on the tax return are sales, total costs and profit for any particular tax year.
As a limited company the directors have a number of further duties than those of a sole trader. A director will still be required to file a self-assessment tax return to disclose any amounts extracted from the company by way of a salary and dividends. There will be extra administration in the form of an annual return and limited company accounts prepared in accordance with the Companies Act. These documents will need to be filed annually with Companies House. The details of the director and a very short from of these accounts will be available on public record. A corporation tax return will also need to be filed with HM Revenue and Customs and in most circumstances a payroll service will be required to declare directors’ salaries. In nearly all instances a limited company will require the services of an accountant to advise on how best to extract funds from the company and to prepare the relevant documents. Generally, the extra accounting costs of a limited company compared to a sole trader will be in the region of £1,000.
The key legal difference between trading as a sole trader or as a limited company is that of limited liability status. As a sole trader you and the business are the same entity, there is no legal separation. A limited company, however, is is a separate legal structure.
As a limited company, so long as you have complied with your duties as a director, you should not be held personally liable for any liabilities that arise in the company – subject to any personal guarantees made. Limited liability status can prove to be of great benefit if you work in a sector where there is the potential to be sued; any liability is simply limited to those assets owned in the name of the company whilst your personal assets remain protected.
For a number of years it was relatively clear-cut in regard to the benefits of incorporating for tax purposes at most levels of profitability. From the 6th April 2016 there are some changes to the way dividends extracted from the company will be subjected to personal tax. This change makes the decision less straightforward.
Most individuals for the 2016/17 tax year will be entitled to a personal allowance which allows the first £11,000 of income to be earned tax-free. After this tax-free allowance most types of income are generally taxed at 20% at the basic rate of tax (up to a total income of £43,000) with a 40% tax rate thereafter. At levels above £150,000 an addition rate of 45% applies.
If you are self-employed you also pay two types of national insurance (Class 2 and Class 4), Class 2 is at a flat rate and Class 4 is paid based upon the level of profits made in the business, although the Government has said it plans to abolish Class 2 NICs by 2018.
Tax applied on dividends differs in that from 6th April 2016 you receive the first £5,000 that would otherwise be subject to tax at a rate of 0%. Any further dividends received in the basic rate of tax (less than £43,000) now attract a 7.5% tax charge (all dividends were taxed at 0% in the basic rate of tax pre-6th April 2016), with tax charged at 32.5% at higher rates and 38.1% in additional rates of tax.
As such, assuming your only income is either from self-employment or extracted from a limited company at the most tax efficient levels, the following savings occur from trading as a limited company:
If you have profits of £20,000, your tax as a sole trade will be £3,020 and as a limited company £2,512, meaning a saving of £508. If your profits are £30,000, your tax as a sole trader will be £5,920 and as a limited company £5,112, meaning a saving of £808. If your profit is £40,000, your tax as a sole trader will be £8,820 and as a limited company £7,712, meaning a saving of £1,108. If your profits are £50,000, your tax as a sole trader will be £12,630 and as a limited company £10,312, meaning a saving of £2,318. If your profit is £60,000, your tax as a sole trader will be £16,830 and as a limited company £14,564, meaning a saving of £2,266. If your profits are £70,000, your tax as a sole trader will be £21,030 and as a limited company £19,164, meaning a saving of £1,866.
We would generally advise that the decision to trade via a limited company should no longer be solely focused on the tax savings offered.
Whilst there is still scope to reduce tax overall this is reduced from 2016/17 onwards and, for many levels of profitability, could be negated by the extra accounting costs and administration associated with trading as a company. A wider decision should be taken as to whether overall the limited company status could offer a significant benefit to the business, either due to unforeseen liabilities that may arise or the general perception of your business by potential customers.
*John Falcon is Director of JF Financial. Modern Accountants for Freelancers, Contractors and Small Businesses.
Disclaimer: The information provided in this article is of a general nature. It is not a substitute for specific advice in your own circumstances.