It is a question that often arises with clients – should I incorporate my business? As with many questions in life, the answer is rarely straightforward and will depend on the specific circumstances relating to that individual and their business.
Before listing the pros and cons, let us first state what a limited company is. It is a legally separate entity that has separate tax and accounting reporting requirements. Accordingly, it is taxed under separate rules – i.e. those concerning corporation tax. The business owner will hold shares in the company and can receive dividends. They are also (normally) the business director and can be paid a salary. These will still require reporting separately for income tax purposes.
Pros
Limited Liability
The clue is in the name – a limited company will limit your liability should you ever find yourself at the end of legal action. Say you are a film producer and an accident on set left an actor injured. If you are a sole trader, you could be sued and the claimant could come after your personal assets (your house, your car etc.), but if you were operating through a limited company, only its assets are at stake. So, the company could go bust but you would still have your personal assets (unless you did something fraudulent, trading insolvent or give personal guarantees). It should be said, a robust insurance policy will normally give as much protection as a limited company and I would highly recommend having good insurance in either set-up.
Tax Saving
Without going into the details, operating through a company will present a tax saving on the same amount of profits. This is because dividends do not attract National Insurance. To ensure you still receive benefits connected with National Insurance Contributions (e.g. receiving a state pension when you retire), you can also pay a small salary to accompany the dividends. However, due to the added costs of running a company (more on that below), it is often not worthwhile incorporating until you are earning at least £50,000 in profits.
Income Smoothing
A sole trader will pay taxes on all its profits whether or not it is withdrawn from the business. If you do not need all the profits you earn each year, then you can leave the excess income in a company and only be taxed on what you withdraw. This effectively smooths your personal income and allows some flexibility in tax planning. For example, you lose your personal allowance when your income exceeds £100,000, so you could limit the dividends and salary to this amount. Similarly, if you and your spouse were both shareholders, you could each take out £50,000 and ensure you still receive child benefit, which starts to be restricted above this level. Also, any excess income can be reinvested into the business if required without being taxed personally. Some people use their companies like pension pots and can either pay dividends out from historic profits into their retirement or liquidate the company and (depending on the circumstances) obtain favourable capital gains tax rates on the lump sum.
Reputation
Some customers like to see that they are working with a company. The more rigorous accounting standards a company has to follow it can reassure customers they are dealing with a more professional outfit. Furthermore, the fact there is publicly available information allows the other party to do some checks into the business. This might give them some added comfort in doing business. For example, if you were looking to engage a builder, you would be more encouraged to see a company that has been trading solvently for ten years rather than a sole trader with no public history.
Share Structures
You can choose a share structure that suits your business and allows flexibility. For example, if you wanted to split the income with your spouse, you could give them half the shares. Also, if you have a business partner that does something slightly different or generates more or less income, you can be given different classes of shares that allow for the dividends to be paid at different rates (dividends in the same class have to paid at the same rate per share).
Specific Tax Reliefs
There are certain tax reliefs that can only be obtained by companies. This includes Research and Development Tax Relief, Creative Tax Relief (Film, TV, Animation, Theatre, Video Games, Orchestra), share incentive schemes, such as EMI, and investment schemes, such as EIS.
Other Remuneration Strategies
As well as dividends and salary, you can withdraw cash in other ways. For example, if you use a personally-owned commercial property to run the business from, you can charge the company rent (although, of course, this would be taxable too). If you have loaned the company money you can be charge interest, which can be an efficient tax route depending on your other income. Also, any pension contributions the company makes on your behalf would often be a tax efficient withdrawal of profits.
Cons
Added Professional Cost
Due to the added complexity of operating a company, there will be higher professional charges from accountants. This is to reflect more detailed accounts that need to be filed with HMRC and Companies House, plus an additional tax return is required for the company. Also, depending on your remuneration strategy, you may need to operate a payroll scheme. On top of that, there are annual charges for filing at Companies House (although this are modest). As there is more complexity with share structures and other company law issues, you might need to engage a lawyer to review shareholder agreements to avoid disagreement in the future.
Public Filings
You have to file your accounts and other details, such as names of directors and shareholders, annually with Companies House. While the information disclosed for a smaller company is restricted, ensure your accountant knows the minimum disclosure. (You would be surprised about how much is over-disclosed and then this information is permanently on the record. For example, there is no requirement to report your annual profits, and while most accountants do know this, they still report the amount of tax the company has paid thus allowing the reader to work out the taxable profit.) As your company needs a public registered office, you will need to be comfortable having an address online that anyone can find, or you can pay for virtual registered offices where any post is sent.
Company Law
The directors are bound by company law and there are strict record-keeping requirements, including your financial bookkeeping, company registers and minutes of meetings. Meetings need to be held for declaring dividends and at least once annually. If a person has been previously disqualified (for trading insolvently, for example), company law prohibits them from operating another company for a set period of time.
IR35 Risk
Often freelancers operate through a company when engaging with their customers. There are tax rules, known as IR35, that prevent workers that should be on the payroll as an employee from saving the associated taxes. This means any tax savings will be overridden. It is the individual’s company rather than the customer who is exposed to these taxes.
Double Taxes
There are certain occasions where profits or gains could be taxed twice and it would be less efficient than operating as an individual. For example, if you used a company to buy a residential property to let out, when you come to sell this property, the gain will be taxed in the company first then the distribution from the company will be taxed on the individual. Personal ownership, which is then taxed via the capital gains route is likely to be more efficient (although this will depend on the exact circumstances). There can also be issues when matching foreign tax liabilities if the foreign tax laws “look through” the corporate entity and tax the individual underneath. The result could paying foreign tax and UK tax on the same income.
Mortgages
The risk with income smoothing is the income is being artificially supressed and some mortgage providers will only look at what is shown on the individual’s tax return. For example, if the business profits are £100,000 but you have only withdrawn £50,000 as dividends over the last few years, the mortgage you can obtain might be half the size of what you could have obtained as a sole trader. Of course, the shareholder could withdraw more cash each year, but given mortgage are typically assessed on historic income, it might take a couple of years before you have “proof” of your actual income.
Conclusion
These are just some of the pros and cons of running a company. There can be industry specific issues that should be considered. For example, a private tutor would not need to VAT register if they were a sole trader as there is a specific exemption for private tuition for subjects taught in school (including dance, drama and physical education). However, if the tutor operated through a company, they would be installing an employer relationship (the tutor would be employed by the company as a director) and this is not covered by the exemption.
Finally, while a limited company might not be appropriate, a limited liability partnership might be more suitable (but that’s another subject for another article). Therefore, it is always worthwhile discussing with an accountant before you take the decision to incorporate.
These are general examples and not formal advice. Also, tax law is constantly changing, so the issues discussed here might now be out of date. Each taxpayer is different; therefore, we recommend that you consider your options carefully with an expert before taking any actions.
If you want to discuss any of the above, or any other matter, just give us a call on 020 7183 3383 or email info@kma-spotlight.com.
