What factors should you consider when deciding whether to be self-employed or operate through a limited company.

FACTOR 1 – LIMITATION OF LIABILITY

The main commercial advantage of running a business through a limited company is the limited liability status.

This status protects the owner-managers own personal assets against commercial risk unless, in their capacity as company directors, they knowingly continue to trade and incur liabilities when they knew the limited company was insolvent.

This advantage that a limited company would have over a sole trader is eroded by the following points: –

The owner-manager of a limited company may find that the only way to obtain bank finance or another form of credit is to give a personal guarantee thereby negating totally the limited liability status of the company.

The sole trader may obtain sufficient public liability insurance to negate any commercial risk.

Nevertheless, most entrepreneurs find the limited liability status the most important factor in deciding whether to run their business through a limited company.

FACTOR 2 – FINANCIAL STATEMENTS

The records that a sole trader needs to maintain can be very basic and, therefore, a formal accounting system may not be required. However, this will change when the new Making Tax Digital system comes into force.

Currently, the records can just be a basic list of sales and purchases supported by invoices.

The final account prepared by the sole trader may consist of a simple income and expenditure account with no balance sheet.

The accounts of a sole trader do not become public record.

Due to this simplicity, the services of an accountant may NOT be required.

The records that a limited company has to maintain are far more formalised. The limited company will have to use a double entry bookkeeping system because the final accounts that the business will need to prepare will include a profit and loss account and a balance sheet together with statutory notes and statements.

Also, if the limited company’s turnover is greater than £10.20 million, then the business will require an audit for which the cost will be in the thousands.

Furthermore, the accounts of the limited company are required to be filed at Companies House so that they become public record.

To summarise, limited companies are faced with additional administrative burdens which may result in increased professional fees.

FACTOR 3 – ADMINISTRATION, MANAGEMENT AND BUSINESS STANDING

A sole trader basically pleases themselves with regard to the administration and management of the business. A company director is responsible for adhering to company administration according to statutory regulations in regard to both the limited company accounts (as described above), statutory records and management function as stated in the articles of association. The duties of a director are more formal than a sole trader.

Forming a private limited company is an indication that a business is both serious, has a long-term objective and is correctly managed. This perception can increase the business standing of a business. In addition, any funding requirements are more likely to be met as the lender to a sole trader has to consider the absence of a balance sheet statement in the basic accounts and the financial influences personally affecting the sole trader. A private limited company advantages concern the published financial statements, protection of the financial position from personal influences and the option of increasing security by virtue of asking directors to provide additional personal guarantees.

A private limited company advantages over self-employment also extends to long term finance. Companies tend to retain more funds within the business to meet future financial commitments which aids year on year growth, a more sustainable business and medium-term profits growth over a sole trader.

FACTOR 4 – TAXATION

In recent years, the lower rates of Corporation Tax have given a private limited company a smaller advantage over self-employment.

While Corporation tax rates have reduced to 19% for all limited companies the basic rate tax for a sole trader is now at 20%. Despite these changes, incorporation does still offer tax saving advantages dependent upon the net profit before tax.

The limited company also offers the flexibility of the owner-manager determining the proportion of dividends and salary that they can draw from the business while a sole trader is subject to fixed tax rates and thresholds.

Even when profits are fairly small, the use of the limited vehicle seems to give the owner-manager an advantage over a sole trader. This advantage is increased due to the flexibility of how and when the owner-manager draws that profit for his own personal use.

However, there are a number of other points concerning taxation that need to be factored into the equation

PENSION CONTRIBUTIONS

Pension contributions of a sole trader are personal and, while they may be deducted from the personal income liability of the sole trader, they do not form part of the basic accounts.

The pension costs including any company contribution to a pension scheme by a limited company is a deductible business expense as an employee cost.

MOTOR VEHICLES

Using a car for business purposes may have an impact. The sole trader basic accounts would include the business proportion of the vehicle running costs or the mileage allowance.

If that vehicle is used by a director of a limited company, then that director is receiving a taxable benefit potentially resulting in a higher tax burden depending upon the type of vehicle as taxable benefits vary.

An alternative for the owner-manager of the limited company may be to leave the company vehicle privately owned and the director claim mileage allowances rather than vehicle running costs.

ACCOUNTING TREATMENT OF DEDUCTIBLE EXPENSES

There ARE differences in the accounting treatment of deductible expenses such as charitable donations, entertaining expenses and use of home as office.

A limited company has a more generous deduction system consisting of being able to claim such expenses as valid business expenses which, otherwise, would not be claimable in the sole trader basic accounts.

IR35

Knowledge based businesses (i.e., IT Consultants) need to be aware of the IR35 legislation which may render the tax advantage of paying a nominal salary and substantial dividends unobtainable.

CHILD AND WORKING TAX CREDITS

The owner-manager needs to consider the impact of dividends received just within or just outside of a tax year.

Consideration also needs to be given to the rules concerning the impact of an increase of income would have on a taxpayer’s tax credit claim. The original tax credit claim based on the taxpayer's previous year’s income will not be altered unless the actual income for the year has increased by more than £25,000.

INCOME SPLITTING

After HMRC lost the Artic Systems case, many owner-managed companies have paid dividends to the owner-managers spouse.

The Inland Revenue announced that they were going to introduce legislation to combat this income shifting.

However, it seems the HMRC are not going to introduce legislation for the foreseeable future so planning involving payments to non-working/low-income family members can be implemented.

OTHER TAX MATTERS

The owner manager also needs to consider: -

The extent to which borrowed monies need to be repaid out of post-tax profits.

The extent to which monies will be required to fund the acquisition of fixed assets.

Any imminent changes in tax rates.

A magnitude of factors should be taken into account before deciding whether or not to incorporate. Professional advice should be received in all cases before a decision is made. Maybe, it is worthwhile deferring that decision for a short period to establish whether the businesses proposed model actually works.

LIMITED LIABILITY PARTNERSHIPS

In 2001, legislation was passed to allow for another business vehicle to be established the “Limited Liability Partnership”. It is a hybrid of a sole trader and a limited company because: –

The partnership receives its limited liability status and is subject to strict statutory requirements.

It is taxed similar to a sole trader.

This type of business vehicle is gaining in popularity and is especially popular with professional concerns such as accountants and lawyers.