Limited Company: The Pros and Cons of Incorporation for Your Business

When considering the most appropriate and advantageous structure for a business, it is important not to focus purely on the headline direct tax position, although of course this is a significant consideration.

Apart from the annual corporation tax/income tax comparison, other factors to consider may include:

  • Is there a significant business risk meaning that the business should be in a limited company or Limited Liability Partnership in order to protect personal assets as far as possible (note that banks etc will almost certainly take a personal guarantee from the directors on any borrowings though)?
  • Is there a desire to involve third parties in equity ownership now or in the future (employee share options, outside investors)? If so, a limited company is the likely best option.
  • Will customers of the business insist on a certain structure in order to engage, for example in the contracting sector?
  • Are there other businesses which you wish to keep separate from a VAT turnover perspective? A new company or LLP will have its own VAT threshold which may be useful if you wish the new, or existing business to remain under the threshold, or if there would be a partial exemption issue for example.
  • Is there a perception from potential customers and other stakeholders which gives one structure an advantage over another?
  • Is filing documents at Companies House a concern from a privacy perspective?
  • What are the future plans for the business? A third party sale is generally more straight forward when selling company shares than a sole trade or partnership business.
  • Is the business owner prepared to accept the legal responsibilities of being a company director, and happy with the extra record keeping requirements, and in particular able to separate out company funds from personal funds? Note also that accountancy and bookkeeping fees are likely to be higher.
  • Where multiple business owners will be involved, then if flexibility on allocating profits year on year is desired, then a partnership or LLP may be more appropriate than a limited company where dividends are paid out proportionally to shares (although there is the possibility of adding the complication of different classes of shares – be careful to ensure there is a commercial justification for this in case HMRC enquire).
  • Is there scope to provide a spouse with income from the business as salary (commercial rate) or dividends (care with settlements legislation) from the business
  • Consider the tax effect of mixed business and personal cost items, for example car usage, use of home

The direct tax comparison

Until the changes to the taxation of dividends in 2016 (see separate factsheet https://crmoxford.co.uk/news/changes-taxation-dividends-april-2016/) then in many instances, there was a clear tax advantage in operating a small business through a limited company.  This is not necessarily now the case, particularly if most or all of the profits are withdrawn as income rather than left in the company for retention/investment etc.

The following examples use 2018/19 rates (note that the dividend allowance reduces from £5,000 to £2,000):

Basic rate taxpayer:

 Sole traderCompany Sole traderCompany
      
Profit         25,000         25,000          40,000         40,000
      
Salary                  –           8,424                   –           8,424
      
Corporation tax                  –           3,149                   –           5,999
      
Dividend                  –         13,427                   –         25,577
      
Personal tax           2,630               600            5,630           1,511
      
Personal NIC           1,645                  –            2,995                  –
      
Net income         20,725         21,251         31,375         32,489

Higher rate taxpayer:

 Sole traderCompany Sole traderCompany
      
Profit         50,000         50,000          80,000     80,000
      
Salary                  –           8,424                   –        8,424
      
Corporation tax                  –           7,899                   –     13,599
      
Dividend                  –         33,677                   –     57,977
      
Personal tax           8,360           2,119          20,360        8,955
      
Personal NIC           3,639                  –            4,239               –
      
Net income         38,001         39,982         55,401     57,446

You can see that the differential at most income levels is quite marginal, especially when you take into account the additional compliance and filing costs associated with a limited company.  Therefore, for businesses which intend to withdraw most or all of their profits as income, then the other factors outlined at the start of this document may be the more persuasive ones.

However, where profits are not to be drawn out in whole, but to remain in the business for expansion etc, then this is where a tax advantage occurs for the limited company structure:

Basic rate taxpayer:

 Sole traderCompany Sole traderCompany
      
Profit         25,000     25,000      40,000     40,000
      
Salary                  –        8,424                –        8,424
      
Corporation tax                  –        3,149                –        5,999
      
Profit retained         5,000       10,000
      
Dividend                  –        8,427                –     15,577
      
Personal tax           2,630           225         5,630           761
      
Personal NIC           1,645               –         2,995               –
      
Net income/retained profit         20,725     21,626     31,375     33,239

Higher rate taxpayer:

 Sole traderCompany Sole traderCompany
      
Profit          50,000     50,000          80,000       80,000
      
Salary                    –        8,424                   –          8,424
      
Corporation tax                    –        7,899                   –       13,599
      
Profit retained      10,000         25,000
      
Dividend                    –     23,677                   –       32,977
      
Personal tax             8,360        1,369          20,360          2,066
      
Personal NIC             3,639               –            4,239                 –
      
Net income/retained profit          38,001     40,732         55,401       64,334

This means that the capital in the business can build up far quicker by using the company to effectively shelter the profit which is not required as personal income from higher rate tax.  Naturally, the greater the amount of profit to be retained in the company, the greater the tax savings can be made.

Summary:

The decision to incorporate or not incorporate can be a complicated issue, with conflicting points on both sides.  In each case, it is ultimately a personal decision for the business owners as to which factors are most important for them in their circumstances, rather than being a pure tax driven decision.

If you would like to discuss your personal circumstances, then please call us on 01865 379272.

Disclaimer

This document is prepared as a generic guide and does not constitute tax, financial or any other advice. The applicability of tax and other rules will depend on your individual circumstances.  You should consult a suitably qualified and experienced professional before making decisions. No responsibility can be taken for any loss arising from action, or inaction, taken as a result of the information in this guide.  This factsheet is based on our understanding of the legislation as at September 2018.

© Chapman, Robinson & Moore Ltd 2018.  All rights reserved.