Sole trader, partnership or limited company?
Or it could be a CIC (Community Interest Company) but we will focus on the most common dilemma of whether to set up a limited company, form a partnership or operate as a sole trader.
Limited Company formation is a straightforward process that you can do yourself at Companies House, fees change but at the time of writing this costs £50 – be careful as there are many company formation agents charging many multiples of this. One thing to consider is your registered office – once your company is formed your registered office will be available to the public on the Companies House search, so think carefully - it may be beneficial to find an accountant such as Clough Accounting and use them for your registered office address.
What are the benefits of forming a limited company?
A limited company is separate to you personally, and is owned by the shareholders. In the case of large companies there are many shareholders and many shares that may or may not be traded on a stock exchange - for start up companies you are likely to own all of the shares yourself. The benefit of the limited company being a separate legal entity to you personally is primarily in terms of liability if things go wrong – although this will probably seem unimaginable as you set out on your journey, only around 40% of UK companies survive to their five year anniversary, and after this point around half of the surviving companies grow whilst the other half do not.
If your company folds with debts, the directors are not normally obliged to repay these, unless they have offered directors’ guarantees on leases or borrowing or are found to have committed misfeasance or malfeasance – for example continued to trade an insolvent company, or acted in their own personal interests rather than those of the company. Most banks will be unwilling to lend to a new limited company unless you sign a director’s guarantee, effectively making you liable for the debt personally if the company defaults on the bank debt. And you may be putting your life savings into the company too, so there are ways of losing everything even if you do operate as a limited company.
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Limited companies are taxed differently to sole traders and partnerships, this falls under corporation tax rather than personal tax, although as a director you will also need to complete a personal tax return. You may take a wage from the company as a member of staff, for which you will require a payslip, and there may be a director’s loan account balance that you owe to the company or vice versa. Overdrawn director’s loan accounts can attract a tax charge, it is generally best to keep the balance below £10,000 to avoid having to pay interest, national insurance and corporation tax on the loan.
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If the company is profitable you may take a dividend from the company. This has already been taxed at a corporation tax rate of between 19% and 25% as company profit, and you will need to pay a further dividend tax on your personal tax return. The tax rate on dividends depends on your total income for the year, basic rate tax payers are taxed at 8.75% on their dividends, higher rate taxpayers at 33.75% and additional rate taxpayers at 39.35%, although the first £500 in dividends is currently not taxable because of the £500 dividend allowance, an allowance that is shrinking steadily over the years.
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If you are asking yourself whether it is worth setting up a limited company, there is no clear answer, because it depends on what you personally have to lose, how much is being invested up front, and the sector the business will operate in - you can look at the tax implications on our take home pay calculator for sole traders and limited company directors. It all sounds rather complex at first, which is why having a good accountant on your journey matters, and you may want to consider booking a free 30 minute zoom call with us here, during which we can help you to decide whether a limited company is the correct approach for you.
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At Clough Accounting we don’t leave things to the last minute, so before your year end we will prepare some draft company accounts and estimate company profitability – at this point we discuss directors’ salaries, potential dividends, and the beauty of this approach is that you may be able to make some capital investments to reduce your corporation tax liability before it is too late. We can only do this for clients who are well organised, for others it can be a race to get accounts filed before the filing deadline, Companies House late filing penalty fees range from £150 to £1,500 for a private limited company depending on how late the filing is.
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In summary, forming a limited company is easy but results in a lot of paperwork and admin further down the line, and your accountancy fees will be higher than if you operate as a sole trader. The protection offered to your own capital can be worth this. The tax advantages of being limited have been eroded over recent years by rising corporation tax rates and falling tax-free dividend allowances to the point where there isn’t a great tax advantage from incorporating a limited company.