Limited Company or Sole Trader?
Mark Thompson Chartered Accountant in Warrington gives insight into a frequently asked question: Limited Company or Sole Trader? Small business owners can pay much less tax and national insurance if they trade via a limited company. This article explains how this can be achieved and what magnitude of savings are possible.
When I trained as an accountant 25 years ago, i distinctly remember being taught that you shouldn’t let the tax tail wag the business dog. However, when the tail is very large and waggy it can be extremely difficult to ignore! Consequently, during the last decade many businesses have chosen to incorporate because of the tax savings that are available. The magnitude of those tax savings is dependent upon how profitable the business is. The greater the profit, the bigger the potential saving.
Every small business owner, without exception, could pay less tax and national insurance if they traded as a limited company rather than a sole trader. However the magnitude of that saving for a business with low profit levels is likely to be outweighed by additional costs and administrative burdens. To give you an idea of the level of savings that are possible:
Profit = £10000 the potential saving is £305-62
Profit = £20000 the potential saving is £1205-62
Profit = £30000 the potential saving is £2105-62
Profit = £40000 the potential saving is £3005-62
Profit = £50000 the potential saving is £4264-99
Profit = £60000 the potential saving = £4464-99
The private limited company advantages come from the flexibility of being able to determine the proportions of salary and dividends taken compared with a sole trader whose profits are subject to tax at fixed tax rates and thresholds. To maximise the level of tax saving, the Director should take a relatively low salary (say equivalent to the standard personal allowance of £7,475) and pay the balance of any other income in dividends. This will minimise the amount of tax and national insurance payable – primarily because national insurance is not payable on dividends. In each of the above examples, the director is paid a salary £7475 and the remainder of the profit is paid as a dividend. It is extremely important to ensure that the business owner extracts their income in a low salary : high dividend ratio. If all or the majority of the income was paid out as a salary then the owner would end up considerably worse off than if they had been operating as a sole trader.
Once the profits reach a certain level the financial benefits of being a limited company tend to stay at the same level. For example, if you look at the above examples somebody who earns £50k is £1259-37 better off than somebody who earns £40k but someone who earns £60k is only £200 better off than somebody that earns £50k.
As i stated earlier, the amount of tax and national insurance that can be saved varies enormously depending upon the amount of profit that your business generates. To see what affect the different methods of trading and paying yourself could have on the amount of net income that you could extract from your business try inputting your most recent/forecast profit into this tax calculator:
The tax advantages enjoyed by limited companies can be extended even further if net taxable profit is above the level at which a self employed person would pay higher rate tax of 40%. This is because money can be left in the business and therefore only subject to the 20% corporation tax rate thereby avoiding the higher tax rate of 40% that would be levied on a sole trader. The surplus can then be extracted in a subsequent year. Another possibility might be to distribute the shares among family members to reduce the risk of 40% tax.
However, tax should not be the only issue considered when deciding whether to be a sole trader, partnership or limited company. There are numerous other advantages and disadvantages associated with becoming a limited company compared to being a sole trader. This is by no means an exhaustive list but some of the more significant issues include:
1. Limitation of Liability
There is no distinction between business money and personal money for anyone self employed as all business debts are the personal responsibility of the sole trader. The private limited company advantages are that the company is a separate corporate body and the liability for payment of debts stops with the private limited company. The owners and shareholders are not personally liable. The directors are only liable if they continue to trade and incur liabilities after it becomes apparent the limited company is insolvent.
2. Limited Company accounts vs Sole Trader accounts
The accounts that a sole trader has to produce are far less complicated than those demanded of a limited company. Sole trader accounts can be quite simple. A formal accounting system is not required and can be reduced to simple lists of income and expenditure supported by documentary evidence of sales and purchase invoices (- although care should be taken to ensure that they are sufficient to meet the level of recording demanded by HMRC). Producing a balance sheet is optional. Due to this simplicity an accountant may not be required, thus producing a significant cost saving.
Limited company financial statements must include a balance sheet with statutory notes. These have to be filed at Companies House within 9 months of the year end. Accounting software may well be required to produce the company accounts in this format as well as at least a basic knowledge of accounting techniques. Whilst engaging an accountant is not essential for a small limited company it would certainly be advised. An accountant’s fee is likely to be in excess of £500 depending upon the size of business and standard of accounting records maintained. This clearly offsets some of the savings obtained from lower taxes.
A sole trader does not need to calculate payroll if they do not employ any staff. However if the business is run through a limited company, the business owner is an employee. Payroll will need to be calculated at the very least on an annual basis and the required returns submitted to HMRC.
4. Withdrawing funds from the business
It is much easier to withdraw funds from a sole trader business than it is from a limited company. A sole trader can withdraw funds from the business whenever they want. The funds are theirs to do with as they please. However, if the business is operated via a limited company then the director can only withdraw funds by either salary or dividend. Furthermore, prior to declaring a dividend, they must satisfy themselves that sufficient profits have been generated to cover paying that dividend. If funds are withdrawn in excess of the director’s entitlement to salary and dividends then interest and tax is likely to be payable.
5. Additional financial considerations
Pension contributions of a sole trader are personal and so do not form part of the basic accounts. However, the pension costs including any company contribution to a pension scheme by a private limited company is a deductible business expense as an employee cost.
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. However, if a directors uses a vehicle that is owned by a limited company for personal use then that director is receiving a taxable benefit potentially resulting in a higher tax burden. An alternative may be to leave the company vehicle privately owned and the director claim mileage allowances rather than vehicle running costs. If the vehicle is a company vehicle and used personally, the company will have to submit further forms to HMRC on an annual basis.
6. Administration & management
A sole trader to a large degree pleases themselves with regard to the administration and management of the business. However a company director is responsible for adhering to statutory regulations in regard to the limited company accounts, statutory books and financial management as stated in the articles of association. The responsibilities of a director are much more stringent than those imposed upon a sole trader.
Clearly there are many more issues that need to be considered other than tax savings when deciding whether to be a limited company or a sole trader. However, if the net profit of the business is likely to be in excess of £20000 per year and the owner is disciplined enough to maintain accurate and well documented business records then serious consideration should be given to trading via a limited company.
If you would like to discuss further the pros and cons of being a limited company and whether it would be suitable for you and your business please contact us on 01925 212282 or send an email enquiry here.
(The author does not guarantee the accuracy of any information provided in this article and recommends that you do not take any action, whatsoever, based on the information provided. By the fullest extent permitted by law, the author does not accept any responsibility for any actions you may or may not take based on information contained in this article. This article contains general information and is not a substitute for specific independent professional advice. In addition it is emphasised that much of the information provided in this article is time sensitive. Whilst it is accurate at the date of publication (November 2011) information contained within it may be out of date).