One of the most common questions we find clients asking us is whether to start their new business as a sole-trader /partnership or limited company and what is best from a tax perspective.
In this brief article we attempt to explore and discuss the potential pros and cons of each type of business structure. Please note that the article is intended for general guidance only and any new business should seek the advice of their professional advisors.
Most people will be aware of the term “self-employed” – however, what does it really mean? Here we look at the differences between trading as self-trader or as a limited company. It should be noted that there is no real difference between a sole-trader and partnership set-up other than the profits being split between two or more parties. Hence the same rules that apply to sole-traders also apply to partnership set-ups.
1-Simple set-up and maintenance
Operating as a sole-trader is still the simplest way of starting any new business. There are no set-up costs involved unlike a limited company which needs to be purchased or formed with the Companies Registrar. Moreover, the rules governing sole-traders are not as rigorous as those in place for limited companies who are required to prepare a much more detailed set of accounts.
It is of course necessary to register as self-employed and this can be done online or through an accountant. The deadline for registering is the 5th of October after the relevant tax year the trade commenced. The tax year starts on the 6th of April each and ends on the 5th of April, therefore, anyone wishing to start a new business in the 2014/2015 tax year, needs to register by the 5th of October 2015.
For all sole-traders the 31st of January each year is a key deadline as they will be required to submit their yearly accounts online to the taxman, HMRC and also pay over any final tax that is due.
One recent change which has simplified things further for sole-traders is that since the tax year 2013/2014 sole-traders have been allowed to prepare their yearly accounting to the taxman on a cash basis (providing they are under the current VAT threshold of £81,000 from April 2014). This is a huge advantage as far as accounting is concerned as it allows traders to simplify their accounting and simply base their profit or loss on the actual cash received and paid.
This clearly simplifies things for any new business. Currently, limited companies are not allowed to take advantage of the cash basis for accounting and are instead required to base their yearly accounts on the actual amounts they have invoiced (and potentially not yet received). This can complicate matters. Moreover, by law all limited companies are required to prepare a balance sheet along with the profit and loss account. A balance sheet is a simply a statement of financial position showing the assets of the company and liabilities at any one point in time.
2-Separte legal status
The main issue surrounding self-employment is that there is no separate legal distinction between the trader and the person carrying on the business. This means that if a sole-trader runs up large losses and is unable to pay its suppliers and creditors, it is possible that if the sole-trader is sued they could be called upon to settle the outstanding debts via their personal assets. This is in contrast to a limited company which is distinct and carries separate legal status from its owners.
Hence, the major advantage of limited company status is often said to be the limited liability status enjoyed by its owners. This means that in most cases the personal assets of the individual owners of a limited company are protected should a business fail.
However, often this legal distinction will not be very important for many small traders who would rather prefer the simplicity of trading through a sole-trader set-up and who will not necessarily need to run up huge set-up costs in order to trade and therefore are not exposed to much as a business.
We mentioned that the 31st January is a key deadline for sole-traders as they will need to submit their accounts to the HMRC and also pay over any outstanding tax. Here we look into in slightly more detail the difference between the two business structures as far as taxation is concerned.
Sole-traders only pay income tax on any profits they make from their business. This is simply based on their income less expenses and after making any adjustment for certain allowances and reliefs. The first £10,000 is currently tax free as this is covered by each sole-traders personal allowance. Any profits in excess of £10,000 are taxable at 20% up until £31,865.00 a year. Profits exceeding £31, 865 a year are taxable at 40% up to the limit of £150,000.
Sole-traders are also required to pay national insurance contributions and currently pay two different types, called Class 2 and Class 4. Class 2 is currently paid at £2.75 a week. However, there is an exemption available for very small traders if their yearly earnings are below £5,725. Sole-traders earning over £7,956 to £41,865 a year will also need to pay Class 4 NI contributions currently paying 9% between those earnings. Any earnings above £41,865 pay 2% Class 4 National insurance contributions.
Companies on the other hand are subject to a different type of tax altogether called corporation tax. The current corporation tax rate is 20% for companies with profits up to £300,000 a year. Corporation tax is payable 9 months and one day after the year-end of a company so the 31st of January deadline is not relevant in this case.
Overall which Business Structure is better?
Most small businesses initially start off as sole-traders due to it being so easy to set-up. However, as the earnings and profits of a business increase, the potential tax savings of operating though a limited company become greater. Overall, it therefore depends on the profits made by the business and also how easy businesses want to keep their accounting. We would be happy to advise in further detail at which point it would be more beneficial to trade through a limited company.
One final point we would like to touch on and is often asked is whether any payments made to the business owner(s) are tax deductible. Unfortunately, with a sole-trader any payments made to the business owner are not a relevant deduction (this comes back to our point earlier about a sole- trader not being a separate entity) and are treated as an appropriation of profits. Companies on the other hand can employ their owner(s) and actually pay a salary which is fully tax deductible in the books. This is one of the ways that companies can be structured so that the tax saving position is maximised with their being an optimum level of salary and dividends to utilise full tax savings.
For further information on any points raised in this article, please contact one of our advisors who would be happy to discuss in detail each individual taxpayers circumstances and which business structure would be more suitable.
About HKN Accountants Limited
We are a qualified firm of accountants specialising in new start-up businesses and are formed entirely of qualified accountants based from our offices in South-East London. We are proactive and strive to provide a professional service to all our clients. We fully appreciate that some of our clients are not able to come and visit us directly and we are therefore happy to come to clients.
We offer a free initial consultation and fixed fee pricing so that all our clients are aware from the outset how much they will be paying. We also offer flexible payment terms for all our clients.