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One of the first decisions an individual starting a business will need to make is to understand what structure they wish to adopt. Below we discuss various aspects you should consider. There are many factors to consider and there is no clear right or wrong situation. Feel free to get in touch and we can discuss what may be a more preferential route to take.
All the figures and rates quoted are related to the 2017/18 tax year at the time of writing.
A Sole Trader does not need to do much more than inform HMRC that they intend to become self employed, at which point they will then be obliged to complete a self assessment each year.
For a Limited Company however, there are many more considerations to factor in. Incorporating a company with Companies House means you are required to oblige with much more compliance going forward. Setting up a company also requires a few decisions to be made such as, for example, the structure of shares.
How is each approach taxed?
Sole Traders pay taxes through the Self Assessment process and pay tax based on the amount of their taxable profits in line with the relevant income tax bands. They can typically utilise their personal allowance against this. Sole Traders also pay Class 2 and Class 4 National Insurance contributions depending on their profits.
Limited Companies pay Corporation Tax (currently 19%) on taxable profits, at which point profits can be distributed either as a Dividend or retained for future years. Dividends are then taxed at the appropriate dividend tax bands as part of a Self Assessment. Limited Companies can also elect to pay a Director a salary which would incur Income Tax and National Insurance under the PAYE (pay as you earn) system, again potentially utilising your personal allowance.
Depending on several factors, including the level of profits expected and how the proprietor is intending to extract profits will help determine whether one approach is more tax efficient than another.
A Sole Trader can extract distributable profits (profits available after their tax liability has been paid) without any issues.
A Director of a company however has two main approaches to consider. They can either elect to pay themselves a salary, subject to Income Tax and National Insurance through PAYE or formally declare Dividends subject to Dividend tax rates. Directors must be careful of simply extracting funds from their company. Typically, funds not declared either as a Dividend or as a salary paid via PAYE can be considered as Director’s Loans, which if not managed correctly, can incur punitive tax charges and be considered as a benefit in kind.
Accounts production and returns
A Sole Trader will simply have to produce a self assessment each year to highlight their income and taxable profits. This must be submitted by paper on the 31st of October after the tax year, or the 31st of January the following year if filed electronically. They do not necessarily have to produce accounts, but it may be of help to understand their business and assist with sections of the return. They also have the option to adopt the cash accounting basis.
A Limited Company will have to produce and file statutory accounts each year for their company, complete an Annual Return, and submit full accounts for Corporation Tax returns. Accounts must be prepared in line with accounting standards. Furthermore, each Director is obliged to complete a Self Assessment as a Sole Trader would.
As a result of this, typically accountancy fees for a Limited Company are notably higher due to the level of compliance and complexity of the work involved and the necessity to produce a Self Assessment in addition.
Sole Traders can opt to use their own personal bank account to manage their banking affairs. This may save considerable fees on transactions which a Limited Company may incur. However it is worth checking the terms and conditions of your bank before doing this. It is also best practice to keep your business and personal transactions separate.
Limited Companies however must have a company bank account and cannot use a personal bank account for business transactions.
A Sole Trader is legally the same entity as the business, therefore anyone claiming against their business can equally pursue their personal assets.
A Limited Company however is as described – limited – in terms of their liability and claims can only be made against assets the company holds. There are exceptions in certain circumstances, such as if the director has committed fraud.
For right or wrong, a limited company can help achieve the perception that the business is larger or more established than if they are dealing with a sole trader. Some companies refuse to deal with Sole Traders as a result of this perception.
Considerations for VAT
Regardless of opting for either a Sole Trader or a Limited Company model, VAT follows the same rules irrespective of the decision. If your turnover meets, or is expected to meet the current threshold of £85,000 over a 12 month, you are required to register for VAT and charge your customers for VAT whilst equally being able to claim it back on certain purchases.
Limited Liability Partnership
A third approach for a business with several proprietors is a Limited Liability Partnership LLP. This offers a halfway house between a Limited Company and a Partnership or Sole Trader scenario, in that the LLP benefits from the legal status of being a separate corporate body, however is taxed similarly to a Sole Trader.
There is no simple answer for deciding whether a Sole Trader or a Limited Company is the best approach to take and this varies from business to business, however it is an important decision to make. We can discuss the options and come up with the most ideal route for your company.