Simmons Gainsford Chartered Accountants Small Businesses should you incorporate

Small Businesses – should you incorporate?

Posted on 6th Jan 2011 - Share this blog/article

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Many people assume that being in business is synonymous with running a company. This is not the case. There are actually four alternative common forms of business structure:

  • a sole trader;
  • a conventional partnership (where you work with one or more partners in the business);
  • a limited liability partnership (this provides you and your partners with the protection of limited liability just as with a limited liability company); or
  • a limited company.

Choosing the most appropriate structure for your business is one of the most important questions you need to consider when starting in business.  Once you have decided you may still want to review your choice in the light of changes in legislation and the regulatory environment. When a sole trader or partnership becomes a company it is said to ‘incorporate’.

In this Memorandum we have summarised many of the commercial, tax and practical issues that we know are relevant to most of our clients when they consider the ‘incorporation’ question.  We have also included reference to the rates of capital gains tax on winding up a company.

In recent years there has been a tendency to incorporate solely because the tax system seemed to enable small companies to pay less tax than sole traders and partnerships. In fact this was not always the case, especially if the profits were to be drawn out of the company.  With increasing headline personal rates of income tax and liability to National Insurance contributions, coupled with reducing rates of corporation tax, the trend towards operating through a limited company can only become more pronounced.

COMMERCIAL CONSIDERATIONS

Although some people are tempted to focus on the tax issues it is frequently the commercial considerations that will be more important.

For instance, some professional people are not permitted to operate as companies. This is relevant, for example, to barristers and to the NHS practices of doctors and dentists.

Limited liability

One key reason for favouring incorporation is that it can enable you to operate with the benefit of limited liability. A company is a distinct legal entity and it is the company rather than you personally that would be liable to creditors and anyone else looking for money from the business. In practice your bank and landlord may well insist that you personally guarantee your company’s liabilities so the benefit may be more theoretical than real.

You may consider that it is important to have the protection of limited liability if your business is ‘high-risk’ or particularly prone to negligence or other legal claims.  This might be the case for example if you operate in the building trade or provide certain types of consultancy advice.  A major claim from a customer/client could potentially bankrupt your business and you as proprietor.  If however the business is carried on through the medium of a company your liability would be limited to the amount you have invested in the company.  Instead of you being made bankrupt the company would be forced into liquidation.

Limited companies and limited liability partnerships are two different forms of business structure that will both provide you, as the business owner, with the protection of limited liability.

Employee participation

An important benefit only available if you operate through a company is the facility to establish a share incentive scheme.  A properly structured share scheme offers a method of incentivising key staff in a way which simply would not be possible in an unincorporated business. As a significant or majority shareholder however you would be unable to participate personally in such a scheme.

Confidentiality

All businesses must file certain information with HMRC each year. Limited companies and limited liability partnerships must also file detailed information at Companies House each year, although small companies can file abbreviated accounts.  The Accounts as filed are available to competitors, staff, suppliers and customers for examination. However if you operate as a sole trader or a partnership (other than a limited liability partnership) you will not be required to publish any of this additional information.

Raising finance

If your business will require trade credit or to raise funds this will generally be easier if it is incorporated as a company. Companies also have the ability to raise money under the Enterprise Investment Scheme and Corporate Venturing Scheme which offer tax incentives to third-party investors.

Legal obligations

If your business is structured as a company or a limited liability partnership your annual accounts must be prepared in a specified way that is more sophisticated than you might otherwise require. Company law imposes further obligations on companies in addition to the annual filing obligations noted above.

We can help you deal with all of these obligations but it is still important for you to be aware that if you run a company the company’s money is not yours. It only becomes yours after the company either pays you a salary through the PAYE system or pays you a properly authorised dividend out of what are called ‘distributable reserves’.

You will have two distinct roles as regards the company. You will be a director (and therefore an employee) and paid for your services to the company.  You may be paid a salary and/or bonuses. You will also be a shareholder – which is the technical term for the owner of the company.  Dividends can only be paid to shareholders. It will be important to be clear in which capacity you receive any money paid to you by the company.

There are also special reporting obligations for companies that provide benefits and pay the expenses of directors – even if these are business related. You may also become subject to tax penalties if the company lends you money (which is how any unauthorised cash withdrawals will be viewed by HMRC).

We will be happy to steer you through the various structures and advise which is the best approach in your particular circumstances.

TAX CONSIDERATIONS

Having considered the commercial issues you will of course also want to consider the tax issues.  Will you be able to save tax by incorporating? If only it were that simple!
In this context you need to be aware of the different ways that your profits and income will be taxed if you run your business through a company. You will also want to take account of the tax consequences of incorporating an existing business.

Taxes on business income

If you operate as a sole trader you will pay Income Tax and National Insurance Contributions (NICs) on your business profits.  The same tax regime applies to your share of profits if you are a partner in a partnership or a limited liability partnership. The level of tax and NICs you will pay each year will depend upon your income. At worst the combined top rate of tax and NIC is currently 52% in most cases.  .

Company taxation

If you operate as a company the profits of your business will be subject to corporation tax.  It is important to remember however that income tax may also be payable on any salary or dividends that the company pays to you.

The taxable profits of the company will be identified after deducting all salary payments including those paid or payable to you.  Dividends however are not deducted. Company law requires that dividends are paid out of a company’s reserves which means what’s left after the corporation tax has been charged on the profits.

The rates of Corporation Tax from April 2011 are:

Taxable profits Up to £300,000 20%
Taxable profits £300,001 to £1.5 million 27.5%
Taxable profits Above £1.5 million 26%

From April 2012, the rate of tax on profits over £1.5m will be reduced to 25%. The main rate will be reduced by 1% per annum thereafter down to 23% with effect from 1 April 2014.

Tempting though it may be, you cannot extend  the advantage of the 20% rate by setting up a number of companies, e.g. by having (say) six companies each with a profit of around £60,000, instead of one company with a profit of £360,000.  The tax rate is ‘pro-rated’ in these circumstances, so that no tax saving is achieved.

Credit crunch aspects

If your business is currently making a trading loss, or is likely to do so in the near future, you may like to keep it running outside a company until trading improves.  This is because tax relief for losses is more flexible outside a company.  Legal advice should be sought before implementing this idea.

Taxes on money extracted from the company

As indicated above, if your company pays you a salary this will have to go through the PAYE system. This means that you will pay income tax and national insurance on the amounts you receive. Similar rules apply to most benefits and personal expenses that the company pays on your behalf. Additionally the company will have to pay Employers’ NICs – typically at 13.8% of the salary. However the salary and Employers’ NICs are deductible from profits for corporation tax purposes. Even so, this is not an attractive prospect overall, so many small companies pay only small salaries to the directors.

If, instead of salary, you extract profits by way of dividend, neither you nor the company will be subject to pay NICs, but the company will pay more corporation tax than it would if the profits had been paid out as a salary to you. This is because dividends are not deductible from profits for corporation tax purposes. The effective top rate of income tax on a dividend (for those with income in excess of £150,000) is 36.1%, whereas the top rate (including NICs) on salary is 52% in most cases.   To illustrate the overall tax position for a company with gross profits of £100,000, to be drawn out after payment of corporation tax as dividend, the figures work out as follows for a shareholder with other income absorbing personal allowances and the income tax basic rate band:

Gross profit in company £100,000
Less corporation tax at 20% (£20,000)
Amount available for dividend £80,000
Tax on dividend (£20,000)
Net receipt after tax (£60,000)

For a shareholder who has substantial other income, so that the dividend falls wholly within the tax band for income in excess of £150,000, tax on the dividend will be approximately £28,880, giving a net receipt after tax of round £51,120.

Taxable profits

In addition to the differing rates of tax on personal and corporate profits there are special rules that will affect the way that your taxable profits are computed. For example, certain tax reliefs are only available to companies. Additionally the rules for claiming tax relief in respect of a car or van used for business are different depending upon whether you operate your business as a company. There are also different rules for identifying how much of your household bills can be deducted from your profits. Finally only companies can obtain tax relief for some insurances and life assurance payments. All of these issues will affect the level of your taxable profits.

Retained profits

When comparing the tax charges on business profits it is important to consider the extent to which the business will reinvest profits in the future of the business. If, for example, you know that you will need to repay business loans or buy machinery, equipment or vehicles you will be interested in maximising the level of business profits that are left after paying tax. This often results in people choosing to operate through a limited company.

The same is likely to be the case if the business will be making bigger profits than you will want to withdraw each year.  In such cases the question that arises is: How will the tax rules work when the business comes to an end and the surplus profits are paid out?

In such cases the company will be wound up and may be put into ‘liquidation’. The surplus funds can then paid out and Capital Gains Tax (CGT) will normally be payable rather than income tax and NICs. The standard rate of CGT is now 18%, although this increases to 28% for higher rate taxpayers to the extent that a gain when added to other income for the year is greater than the higher rate threshold for income tax purposes (£35,000 for 2011/12). For gains of up to £10 million the rate may be reduced to 10% if you satisfy the criteria for ‘entrepreneurs’ relief’.  This relief may apply if you own at least 5% of the share capital and are an employee or director of the company.  Although these rates are very attractive as compared with up to 52% income tax and NICs, the company will already have paid corporation tax so overall there may be no tax saving.

If you do not anticipate the need to draw out of the company all of the profits that it makes each year we can help you to forecast the cashflow and tax implications of paying corporation tax and retaining profits in the company.

Double taxation

You should be aware that if you operate your business through a limited company it can seem as if you are paying tax twice.  Once when corporation tax is paid on the company’s profits and then again when you have to pay income tax or capital gains tax on the monies that are paid to you by the company.

This ‘double taxation’ effect is especially apparent when a company makes a profit on the sale of a property or certain other assets.  The company will pay Corporation Tax on the gain and then you will have to pay further tax either when you sell or liquidate the company or when the profits are paid out to you as salary or dividends.

The impact of these rules means that, even if you choose to run your business through a company, it may be beneficial to retain key assets outside of the company. This will enable you to avoid the prospective double tax charge.

VAT issues

If you are registered for VAT you will need to decide whether or not to transfer your existing VAT number to your new company or whether the company should register separately. Which approach is best will depend upon your VAT compliance history and other commercial issues.

The transfer of a VAT registered business to a company may have VAT implications itself but you can avoid these by complying with the rules for a ‘transfer of a going concern’.

Tax issues arising on incorporation

If your business is already established there are a number of tax issues to consider when you transfer the business to a limited company.

The most important one is often capital gains tax. This will be relevant if your business includes certain assets (including goodwill) that would be subject to the tax if you sold the business to a third party. In the first instance tax law dictates that you be treated as if you had sold to a third party. However you can legitimately avoid any such liability by choosing one of three alternative approaches to the incorporation:

  • Transferring the entire trade and assets of your business to the company;
  • Claiming hold-over relief as regards any deemed gains arising on incorporation; or
  • Selling the assets to the new company (even if the sale proceeds cannot yet be paid as the company has no cash), so long as the gain realised on the sale is within the 10% rate of capital gains tax under entrepreneurs’ relief. The proceeds will usually be left outstanding as a debt due from the company to be drawn tax free as and when available profits produce cash funds in the company.

 

We can help you choose which approach is the right one for you. The choice will depend in part on your longer term plans as each option will have a different impact on the calculation of any capital gain when you later sell the company or the company sells the assets.

The other key tax issue you will want to consider is the impact that incorporation will have on your income tax liabilities. This will be particularly relevant if your business annual accounting date is NOT 31 March or 5 April. In many such cases income tax will continue to be payable on your final pre-incorporation profits some time after you incorporate the business. We can help you here by forecasting how the rules will impact your tax cashflows so that you can plan and ensure that you are prepared for the tax bills when they fall due.

Personal service companies

A few years ago the Government introduced tax changes that seemed designed to encourage taxpayers to incorporate their businesses. It became very common for individuals providing personal services (as consultants or contractors) to run their business through a limited company and draw much of the profits out as dividends.  This enabled them to pay much less tax than would otherwise have been due.

As a result the somewhat notorious ‘IR35’ provisions were introduced.  These rules apply when you are working for someone who would treat you as an employee, if you were not operating through a company. The IR35 rules cause complexity in the company tax calculations and prevent you from achieving a tax advantage when drawing dividends from your company. The new coalition government has announced that these rules will be reviewed and reformed with a view to making them less onerous.

Seek advice

You will appreciate from this overview of the key issues that there are many matters to consider before making an informed decision as regards incorporation.

There are very few ‘rule-of-thumb’ solutions.  Careful analysis will be needed in each case to arrive at the right decision taking account both of your short-term and longer term plans for the business.

Timely advice can help you avoid common tax traps and the pitfalls that catch the unwary. Informed advice will also make a significant difference in the long-term.

FOR GENERAL INFORMATION ONLY

Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so.  It is designed to alert clients to some of the issues.  It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.

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