When you’re starting your own business you are probably overrun with tasks that need doing – advertising, networking, designing your website, looking for premises. One of the early things you shouldn’t neglect though is deciding how you’re going to trade (sole trader or limited company) and appointing an accountant. It might seem like something you can ignore until later, but there are advantages to getting it sorted early.
Tax advice is most effective when it is enacted before any event, often it is ineffective entirely if not sought until after your year end has passed and you’re preparing your accounts – for example registering for VAT, selecting a VAT scheme or setting up wages, none of which can be backdated but all of which can save you thousands in tax. You should also decide early on the appropriate structure for your new business as it will have tax ramifications going forward.
The legal differences
Being a sole trader is simple – you register with HMRC, complete a tax return each year and pay income tax and NI on your profits. You are taxed on all the profit you make regardless of whether you spend it or not.
A limited company on the other hand is a separate legal entity, and you can be an employee, director or shareholder. Many people who run their own company are all three, often also appointing members of their family as shareholders and/or employees as there can be tax benefits in doing so. The company pays Corporation Tax on it’s profits and you pay Income Tax and NI on the money you withdraw in salary and dividends. Because you can control how much you take out of the company you can control the personal tax that you pay, and the tax year in which the income is paid to you. This generates various tax planning opportunities that are not available for a sole trader.
Both a sole trader and a limited company are able to register for VAT and PAYE, and the obligations for those are the same regardless of your trading status. A limited company though also has the added responsibility of filing accounts each year with Companies House, and filing an annual return (soon to be a Confirmation Statement) to confirm shareholders and directors. Directors also have to comply with company law and act in the best interests of the company.
There and benefits to each way of trading. A sole trader is easier from an admin point of view and is therefore cheaper in terms of professional fees, but as you’re trading as yourself it means you can be sued and so your personal possessions, including your house, are at risk. A limited company reduces this risk as your liability is limited to the value of your shares, which can be worth as little as £1. There are more ways to mitigate tax liabilities in a limited company, such as issuing shares to family, but the extra work involved will take more time and you will find that accountancy fees can be significantly higher as a result – for example you’re looking at around £250 for a tax return as a sole trader but upwards of £500 for limited company accounts.
The tax differences
A company currently pays Corporation Tax at 20% on it’s profit, but this will reduce to 19% in April 2017 and then to 17% in April 2020. There is no capital gains tax for a company, all gains are simply taxed under the CT regime.
A sole trader will have their business profit combined with their other income and then pay tax as appropriate according to their tax bands – 20% on income from £11,000 up to £32,000, 40% on income up to £150,000 and then 45% thereafter. These tax rates are obviously higher than CT rates, even before National Insurance is also calculated.
A company can pay salary to employees, which are taxed at the same rates as sole trader profits above, and that salary is tax deductible for CT purposes. After paying CT a company can then also pay dividends to shareholders, and this is one of the biggest advantages of trading through a company as they are taxed at lower rates than salary would be (which are the same rates as a sole trader will pay on profits). The first £5,000 in dividend income is tax free, the rate then increases to 7.5% in the basic rate band, 32.5% in the higher rate band and 38.1% in the additional rate band. The right mix of salary and dividends can be very tax efficient.
National Insurance is payable at roughly the same rates whether you are employed via your own company or you’re self employed, but there is no NI at all on dividend income.
You can find more details of the current tax bands and the changes for 2016/17 in our previous blog here.
So what’s best for you?
Before deciding how you’re going to trade bear in mind your overall business goals, and don’t make a decision based purely on tax motives when it might not be the best move for you in other aspects. Think about whether the kudos of a limited company is important to you and your customers, or whether the incorporation and dissolution costs of a company would outweigh the tax saved, especially if you’re trading short term.
If your profit is going to be less than £35,000, and you’re not concerned about the protections limited liability grants you, then sole trader status is likely best for you. The savings you would make from going limited would be outweighed by the professional fees.
If your profit is going to be between £35,000 and £145,000, and you’re happy with a bit of extra admin (most of which you can ask your accountant to draft & submit with your approval) then a limited company is going to enable you to keep more of your hard earned money away from the taxman.
Over £145,000 you’re actually better off from a tax point of view being a sole trader, but again you need to consider the protection a limited company grants you.
What should you do now?
Talk to an accountant. Clarity Taxation offer a free initial consultation, so call us or drop us an email with any questions you may have. We can prepare an income comparison for you so you know what tax you’ll pay under either structure, assist you in registering with HMRC as a sole trader, or help you to set up a limited company at Companies House. On an ongoing basis we can then help with your bookkeeping, VAT, payroll, and prepare your accounts & tax returns. You can see a full list of our services on our website.
Please note that this blog is intended as an overall introduction to the subject matter, and should not be taken to be exhaustive or specific advice. You should discuss your individual personal circumstances with your own professional adviser before taking any action.