Do you prefer profit or dividends?
The difference between these two types of income lies at the heart of the distinction between a Sole Trader and a Limited Company.
Here is an illustration:
If you made £50,000* profit, would you prefer to declare all of it as income and pay £13,310 to HMRC, or pay yourself a very small salary, take out the remainder as dividends and save £2,321?
OK, so saving £2,321 is great but what if it came at the price of quite a bit more bureaucracy and paperwork?
Now let’s look at £100,000 profit:
You declare everything as income and pay £33,630 to HMRC, or pay yourself your very small salary (of £7,488), take out the remainder as dividends and save £3,418.
For £200,000 profit, however, the effect of the higher dividend tax rates kicks in, and savings decline.
The Sole Trader pays £77,580 to HMRC while the owner of a Limited Company saves £1,334.
These figures illustrate the simple tax difference between Sole Trader and Limited Company.
Two Tax Advantages of a Limited Company
The Limited Company comes into its own with the complex tax difference.
Even though tax saving is reduced at higher rates of profit, the figures shown above assume that all of the available profits are treated in the same way as for Sole Traders: they are fully paid out as dividends in the year they were earned.
Limited Companies, however, have the ability to choose when to take money out of the company and pay personal tax on it. Sole Traders cannot do this.
Whilst corporate profits are also subject to the lower Corporation Tax rate of 20% in the year they are earned, dividends can be paid out at a time the owner chooses. They become subject to income (personal) tax only then. As the company owner, you have the freedom to determine how much you draw out and when.
The savings at the lower end may not be life transforming, and even though they are more significant when the higher income tax band is reached, the tax advantages of a Limited Company come fully into play when family members become involved or, should this not be an option, a proper exit strategy is planned.
Significant Reductions in Income Tax Burden
Really significant reductions in income tax burden can be achieved if your spouse or partner and other adult family members share company profits with you. Depending on the level of profit, adding just one person, a spouse or partner, can more than double family tax savings over those of a single owner of a Limited Company.
An alternative option, if there are no adult family members, is retaining any profits above the basic rate threshold in the company and claiming ‘Entrepreneur’s tax relief’ when you finally sell the company. This course of action reduces the tax rate on the retained profits to a mere 10%.
From a purely tax accounting perspective, this is the difference between operating your business as a Sole Trader as opposed to a Limited Company.
There is more to this difference, however, than just tax.
Exposure to risk, perception of your status by your customers and by other businesses, borrowing potential, possible exit strategies and administrative obligations are the other main factors you should consider before you decide on the legal form for your business.
Let’s start with the additional administrative burden as it is directly related to company taxation:
Because a Limited Company is a separate legal entity from its owner, business and tax administration are separate, too.
Limited Companies are all registered with Companies House and governed by rules laid down in the Companies Act (2006). A Limited Company must:
- Keep statutory books (Certificate of Incorporation, Memorandum of Association and Articles of Association)
- Keep accounting records
- Produce audited accounts for turnover in excess of £10.2m
- File company accounts and an Annual Return with Companies House (the Registrar of Companies in the UK)
These legal requirements do not apply to Sole Traders who are not required by law to register their businesses as companies, file accounts and annual returns that are accessible to the public. There are, therefore, no costs associated with starting and operating a business as a Sole Trader. All that is required is registration as self-employed. Of course, Sole Traders still have to complete annual accounts for their tax returns and submitted these to the Inland Revenue.
The tax burden for a Limited Company includes:
- Corporation Tax,
- PAYE (even if the company is a one person operation like a Sole Trader),
- National Insurance contributions and
- Employer’s Contributions.
This makes NI contributions higher than those of a Sole Trader.
The upside is the level of corporation tax charged, which currently (2017) stands at 20% and is expected to fall to 17% by 2020.
By Contrast, Sole Traders only pay flat rate Class 2 NI contributions and Class 4 NI contributions depending on income but have to bear the full burden of income tax on profits, which amounts to 40% for taxable income above £32,000 and 45% for income above £150,000.
Because Sole Traders are the company, they are personally liable with everything they own. They carry all the risk.
Limited Companies are only exposed to the risk carried by their assets. Owners, that is, shareholders of Limited Companies only guarantee with the amount they invested in the company or to the extent that they guaranteed loans by the company. Beyond that, their privately held assets are protected from any claims should the company go bankrupt.
Incorporation as a Limited Company lends the business an aura of prestige as it is perceived as an ‘organisation’. It has an air of stability and soundness that a business operated by a Sole Trader does not have. This has nothing to do with the quality of products or services delivered. It is merely a fact of perceived status.
Another aspect of this perceived status is that many large companies prefer to deal with Limited Companies rather than Sole Traders. This can pose problems for Sole Traders when they want to tender for contracts. Business insurance is generally also easier to obtain for Limited Companies.
Limited Companies can use current assets as security to create a floating charge and thus extend their borrowing capabilities. Sole Traders cannot create floating charges.
As a Sole Trader, you are your business. When you retire, your business retires as good will is directly tied to you. Selling a business as a Sole Trader can be very difficult.
Since a Limited Company has its own existence that is independent from its owner, it can be sold as a going concern with inventory, assets and clients. Generally, good will rests with the company and not the owners or shareholders. Shares are transferable although only shares in Public Limited Companies are allowed by law to be traded publicly.
This sums up the major differences between a Sole Trader and a Limited Company. For Full information that will allow you to decide the legal form best suited to your business, use the Contact form below to contact us or visit the HMRC website.
* Figures in this article do not represent definitive calculations. They are only provided as illustrations.