When starting a small business, you have a few choices on how to legally structure it. You can structure your business as a sole trader, limited company, or a partnership. What you decide on will have a significant effect on the amount you pay in taxes, and when.
Who Is “The Business”
Under UK tax law, sole traders and partners are considered to be the business. This means that any profits generated by the business will be taxed on the individuals in the year they arise.
A limited company is a separate legal entity under UK law, and is responsible for paying Corporation Tax on its profits in the year that they arise.
This distinction is also the basis on which limited companies can limit the liability of their shareholders, as it is the company who undertakes the trading activities and debts, not the individuals personally.
What’s The Benefit?
Aside from limiting your liability, the main benefit is a reduction in your tax bill.
Sole traders and partners are required to pay tax and National Insurance on their profit, at combined rates of 29% for basic rate tax payers (income under £43,000) and 42% for higher rate taxpayers. These rates are payable on all profits made by them, even those that they do not withdraw from the business (remember, they are the business).
Similarly, companies are required to pay Corporation Tax on all of their profits at a rate of 20%. This is set to fall to 19% with effect from 1 April 2017. However, the directors/shareholders are only required to pay tax on their withdrawals from the company, be that salary, dividends or a mixture of the two.This means that owners of incorporated businesses can leave funds in the company, paying only 20% corporation tax. For businesses that a looking to grow using retained earnings, the limited company can offer many benefits.
If you incorporate, the biggest decision you will have to make is whether to have your spouse (or partner) holding a stake in the company. Many people find it beneficial to add their spouses as a shareholder to make them eligible to receive dividend payments, especially where the spouse has limited (or no) other income. This can be an effective way to lower the family’s average tax rate.It is worth noting that HMRC have shown interest in this area for several years, and there are stringent anti-avoidance rules to prevent what HMRC term “income-shifting”. If this is something you are considering, contact our expert Chartered Tax Advisor to guide you through this difficult area.
A Word Of Caution
You might be asking yourself “why wouldn’t you incorporate?”.Before opting for a limited company, it is worth bearing in mind that there are additional professional costs in running a company. This includes annual accounts and company tax returns, as well as filings with Companies House. Another factor is the loss of privacy that comes from having to file (albeit limited) financial accounts with Companies House which can be inspected by anyone, free of charge.
However, for most businesses with profits in excess of £40,000, there is a tax benefit to be had from trading through a limited company that outweighs the additional costs involved.
If you are considering setting up a new business, or incorporating your existing business, speak to Mark today on 0151 489 1010 to see how we can help.