If you have run your business as a sole trader with relative ease, you will be understandably cautious about incorporating it due to the extra obligations and associated costs. However, there will be a right time for many people when they can benefit from the tax savings, having limited liability for the business, developing more credibility and the greater potential for borrowing that a limited company offers. Unfortunately there is no magic sales or profit figure that you can hit, which indicates you should make the change, as every business is distinct and each person has a different personal situation. Other income, from property for example, can greatly affect the decision. However, if your sales are over £50,000 and profit is above £20,000, you should have a conversation with your accountant to investigate the advantages.
To help you consider the pros and cons of switching from sole trader to limited company we have listed some important factors for you to consider. We also offer free accounting advice as part of our one-hour, new client consultation so there’s nothing to lose in contacting us if you don’t already employ an accountant. It is entirely possible to undertake the incorporation process and subsequent accounts and tax returns yourself, but a little advice could mean more pennies in your pocket and the avoidance of penalties if all the Ts aren’t crossed.
> Potential to pay a lesser amount of income tax and therefore take home more
> You will no longer be personally responsible for the company and its losses
> Additional tax deductible expenses against corporation tax are allowed
> More paperwork and returns to Government
> Losses can only be used against the company’s own profits
> You can no longer draw money freely out of your business bank account
How You Will Receive Your Income
Instead of all of the company’s money belonging to you and being accessible to you to take at any time, as a company director and shareholder you will instead be paid a salary and dividends; all of the profits belong to the company. You are recompensed for the latter after the year’s corporation tax is paid and be taxed on these amounts; as a sole trader you are personally taxed on all profits, so should you make the move it’s crucial to keep everything separate with personal and company bank accounts. Continuing with a bank account in your name can result in a nasty tax mess and you must notify HMRC that you are no longer operating on a self-employed basis.
Example of a director’s take home pay:
Your salary is £6,000 – this falls within the personal allowance and under the National Insurance range so you pay no Income Tax or NI
Your dividend is £32,000 – the dividend allowance is £2,000, which you can add the remaining £5,000 of your personal allowance to. This means £7,000 of your dividend is tax free.
Your taxable income is £25,000 – your tax bill will be calculated on the basic marginal tax rate of 7.5 per cent because your earnings haven’t exceeded £46,390. You will pay £1,811 Income Tax.
You take home £36,125 – this is out of the total of your £38,000 earnings.
Limited companies pay corporation tax and no national insurance. In 2018/19 the main rate of tax is 19 per cent (if profits are under £30,000) and in 2020 this will be reduced to 18 per cent. Sole traders can pay a combined 47 per cent Income Tax and National Insurance so there is a marked difference. However, when operating as a limited company you will still personally be liable for personal tax and NI, and you should factor in that corporation tax doesn’t come with a tax free allowance. Furthermore, IR35 is associated legislation that is in place to ensure people aren’t working as contractors using limited companies in order to pay less tax than they would as an employee, so be sure you are compliant.
How Will Your Accountancy Requirements Change?
Accountant’s costs for limited companies are more than they are for sole traders, as there are more undertakings. Therefore, freelancers and contractors will likely want to take advantage of online accounting software, which can process invoices, VAT, expenses and much more to help reduce their own and their accountant’s hours on the books. Cloud technologies take away a lot of the strain that comes with running a limited company – you can read more about our Xero Software offering here, but we are also experienced with a number of other providers, so the best option for you can be discussed.
Instead of one self-assessment tax return you will be required to submit a set of accounts, an annual return and a corporation tax return. If it is advantageous to be VAT registered, there will be your VAT return too. As a director you will need to file a self-assessment, as all directors must, and if you take a salary from the business this must be processed correctly through a company payroll.
If appointing a new accountancy firm at the point of switching company structure, you should be sure to ask about how their charging works. For example, are advice phone calls, communication with HMRC and Companies House or using their address for registration purposes billed for on an hourly basis? When moving to a limited set-up it’s likely that you won’t require full service support, but when your turnover is reaching circa one million pounds our fixed-fee accountancy package, Board Support, is a cost effective option.
Tax Free Expenses
Limited companies can put subsistence claims through their books, so employees, including you as a director, can purchase food and drink at the expense of the company when out on business as well as the travel costs. Entertaining employees is also an allowable expense of up to £150 per employee per year with a limited company, whereas sole traders are restricted in what costs they can claim for.
A More Attractive Proposition
Wrongly or rightly, clients, customers and investors often see limited companies as more professional and able to undertake larger orders or contracts. When looking to proactively grow through investment, incorporation can be a big advantage, as you can easily sell shares in exchange for capital.
Legalities of a Director
If the business is sued, the directors of a limited company are not liable, unless they have been named as a personal guarantor. However, we would advise you speak to your insurance company when changing from being a sole trader to a limited company, and consider additional cover to include costs of defending the directors and officers of a company if personal allegations are made. In comparison, sole traders can find themselves in problematic financial situations as they and the company are legally the same entity; the personal assets of a self-employed person, such as a house or car, can be seized to pay debt.
Nevertheless, directors do have other legal duties, including acting responsibly, ceasing to trade if the business is failing and protecting assets. Directors can be fined or imprisoned if they are found to have not upheld their responsibilities.
If there will be other directors apart from yourself you must agree and record who has responsibility for different areas of the company. Also document what will happen if one of you wants to leave, how the company will be split during a sale and what profits each director can expect to receive.
We hope that our overview has given you a few things to think about, but as each situation is different, we would like to assure you that if you have the right accountant you should never have to get involved with the calculations. At Adams Moore we will help you make all major decisions on changing the structure of your business from sole trader to limited company status; if you’re looking for financial security, separating your personal finances from your business as well as saving money, please call us to arrange a free consultation.