Entrepreneur – should you create a limited company?
When starting up a business, deciding whether to be a sole trader or a limited company is very difficult. Taking into consideration your profits and your business size, which route is the best option for you to get the most tax efficient results?
How is a Sole Trader taxed?
A sole trader will be charged income tax and Class 4 NIC. In the eyes of HMRC, a sole trader becomes the main owner of everything the business owns and therefore is personally charged tax in the form of income tax and class 4 NIC. Everyone has a personal allowance of £12570 where they will be charged 0% income tax. Once the sole trader is earning more than £12570 a year profit, they are then charged 20% income tax up to the higher rate threshold of £50270 a year. Once the sole trader owns over £50270 profit a year, they are charged a tax rate of 40%. This is the same as how an employee is taxed so even though you are a sole trader running a business, you are taxed the same as an employee and additionally do not have the legal protection a limited company has as the tax is in your name. This can become a downfall for sole traders as they are at a higher risk if a tax payment is missed.
Aswell as income tax, a sole trader is charged Class 4 NIC. This is a tax based on self-employment profits and is used to fund state benefits such as the NHS. The tax rate bands are the same as the income tax rate bands but with lower percentages to be charged. It is 0% up to £12570. Then over £12570 up to £50270 it is a 9% tax rate. Over this £50270 basic rate threshold it is a 2% tax rate.
Before you are taxed, you are allowed to deduct allowable expenses you run the business with. For reference, if you are a professional chef earning £94000 a year, you can deduct expenses such as accountancy fees, ingredients and so on. Hypothetically, after expenses you have £72000 profit. From £12570 to £50270 it is always £37700 charged at 20%, leaving you with a £7540 income tax rate charge in the basic rate band. Additionally, £72000 less £12570 and £37700 brings you to £21730, which is what you will be charged 40% income tax as it is in the higher rate threshold. Adding these tax rate charges together; your total income tax is £16,232. Additionally, you will be charged Class 4 NIC. Income at basic rate would again be the figure £37700 and this will be charged a 9% tax rate leaving you with the figure of £3393 to pay. Additionally, there would be £21730 in the higher rate tax band that must be charge at 2%. The total class 4 NIC you would be paying comes to £3827.60. This means your total tax due as a sole trader would be £20,059.60.
How is a Limited Company taxed?
Limited Companies may be exactly the same as a sole trader in terms of services they supply or in terms of profits they make, however, they are taxed in a completely different way to sole traders. Instead of income tax and class4 NIC, Limited Companies are charged corporation tax and dividend tax. Corporation tax is tax taken from the profit of the company. It will be 19% on any profit less than £50,000 and 25% on any profit greater than £250,000. Anything in between £50,000 and £250,000 will be taxed at a rate between 19% and 25%. Often profits over £50000 will be taxed at 26.5% and added to the basic rate figure that was taxed at 19%, which often gives a tax rate figure of around 21% altogether. Additionally, you are charged dividend tax which is taken from your overall profit minus your corporation tax. Dividend tax rate bands are the same as sole trader (income) tax rate bands. You get £12570 free personal allowance. However, the percentages after this differ. From £12570 up to £50270, you are in the basic rate tax band and taxed 8.75%. Over £50270 you are in the higher rate tax band and charged 33.75% tax. Dividend tax plus corporation tax will majority of the time work out to be a lot cheaper than income tax and class 4 NIC, which is why it is a better option for majority of business starters to become a limited company in order to save tax. However, this depends on your business’ profit/turnover, so it is advised you seek professional advice.
Adding to this, a lot of limited company owners pay themselves a small salary and extract further profits as dividends. This is because, National insurance is not payable on dividends, however it is payable on salaries, therefore these limited company directors have this option in order to expand their profits as much as possible. Alternatively, as a sole trader, all your profits are subject to National Insurance.
More advantages of choosing a Limited Company:
As a director of a limited company, any liability for financial losses will be charged against your business, not you personally. Alternatively, as a sole trader, there is no security of limited liability, and any financial losses will be charged against all your personal earnings when in dispute. A Limited company is almost a separate identity a business owner can deal with disputes under rather than damaging their own name.
Unfortunately for sole traders, large corporations are more likely to take you seriously if you own a limited company rather than sole trading. This is because you are registered through Companies House as a legitimate company that larger corporations will be more comfortable to work with. Limited companies come with a lot more PAYE checks and filing to endure however in return they are given more appreciation in the business sector.
Pension Tax Relief
If you have employees within your limited company eligible for pension contributions, these contributions can be deducted as business expenses for the company which reduces the amount of taxable profit the company has. This is a great benefit to having a limited company.
Sole Trader advantages:
There are some advantages of sole traders that could make this route best suited to you and your business. These are:
Less compliance/accountancy fees:
The start up and running costs of a sole trader are lower than a limited company making this the most attractive option for some business starters. This is because there are fewer accounting obligations when you are not a company registered through Companies House. You are also able to deduct tax losses you may have suffered from your business losses to try and lower the overall loss of your business. Also, less regulation from Companies House means less admin and so you have more time to run your business.
You are your own boss:
Your business is yours and only you make decisions for your business. You won’t have boards of directors or shareholders getting in your way unlike most limited companies. However, often the need to become a limited company and add shareholders or directors is a result of an increasingly growing business with higher demand and the need for separate opinions which cannot be prevented.
Quick start up:
Once you have the required licenses and documents needed you can tell HMRC that you are self employed and start trading straight away. Limited Companies face a longer starting up period with additional complicated regulations and longer waiting times to be approved as a company by Companies House.
HMRC taxpayer confidentiality rules protect sole traders, however, Limited Companies are obliged to submit their accounts and company directors to Companies House where all this information becomes available to the public. Therefore, if a company is struggling, this may show in their accounts available to the public which can damage a company’s reputation and give possible competing business an upper hand. Sole traders do not have to worry about these things.