Running your company using the most appropriate structure for you and your business needs is an important question for any owner-manager to consider, but one which is not easily answered.
Whilst this article focuses on the tax considerations in choosing whether to incorporate your business as a limited company, it is often the case that commercial considerations such as the ability to raise finance, limited liability, participation of key employees or issues around confidentiality will be the determining factors in deciding whether or not to incorporate.
However, tax issues should be carefully considered before any decision is made.
Basis of taxation
A person operating as a sole trader will be subject to income tax (at rates of up to 50%) and national insurance on their profits.
However, a company currently pays corporation tax at 20% on profits of up to £300,000, 27.5% for profits from £300,001 to £1,500,000, and 26% on profits above £1,500,000.
Extraction of profits
On the face of it, it appears that incorporating your business using a limited company would save tax. There is always the issue of how money is going to be extracted from the company, though. Any salary or dividends that you pay yourself will still be subject to income tax (and national insurance in the case of salary) in your hands.
In addition, if your company pays you a salary, the company will have to pay employer’s national insurance at 13.8%.
If instead you extract the profits by way of dividend, neither you nor the company will have to pay national insurance, although the company will pay more corporation tax as dividends are paid out of post-tax profits rather than pre-tax profits, as in the case of salaries or bonuses.
If you are thinking of extracting money by way of dividends there are a number of issues to consider, including ensuring that you pay yourself sufficient salary to comply with the national minimum wage legislation.
Retention of profits
Due to this double layer of taxation (i.e. the company paying tax on its profits and you paying tax on monies extracted), whether you will want or need to withdraw all the profits from the company is an important question in considering whether to run your business through a limited company.
If the company is going to require the money to, for example, repay finance or buy large capital assets or if you do not need all the money to live on, then retaining the profits in the company and benefiting from the lower corporation tax rates can be an attractive proposition, particularly if you could sell or wind-up the company at a later date and take advantage of the 10% capital gains tax rate using entrepreneurs’ relief.
Personal service company rules
However, any tax advantage that can be gained from trading via a limited company can be negated if the personal service company rules apply.
These rules apply, broadly, when you are working for someone where you would be treated as an employee were it not for the fact that you were operating via a limited company structure.
A detailed consideration of the applicability of these rules is crucial before any decision to incorporate is made.
There are a number of other tax issues to consider including the different ways in which profits are taxed and the different reliefs available; if your business is loss-making, how you can best use those losses in the future; whether in fact you would be better off trading neither as a sole trader nor as a limited company, but using a partnership structure instead – this can be particularly relevant in a property development or other business where large capital assets are going to be sold.
Tax issues on incorporation
If you make a decision to incorporate and your business has already been operating, then there are tax issues to consider on the incorporation itself, particularly around capital gains tax.
There are a number of options available which can avoid or minimise any tax arising on incorporation but you should always seek specialist advice.