This is a question that I hear a lot, but it is not a one size fits all approach. In most cases operating through a Limited Company is beneficial, but there are some situations where it is not going to suit you, or even some cases where it is not permitted. One of the main benefits though are the tax savings.
Ten facts about Limited Companies
1) Basic tax savings
If you set up your Limited Company correctly with the help of your accountant there can be significant tax savings. There will be some additional costs to consider as there will now be more paperwork such as tax returns, but often once the business has £20,000 income the tax savings outweigh the additional costs involved. Typically these savings equate to the national insurance that you pay.
2) Higher rate tax savings
The headline tax rate for businesses is 20%, whereas individuals can pay up to 45%. As a sole trader if your business generates profits of c.£42k then you will be forced to encroach on the higher tax rates. By operating through a Limited Company you will only be forced into the higher rates if you draw income into the higher rates. Therefore it is your choice if you are taxed into the higher rates or not, (as you could elect to leave some money in the business instead).
I often see situations where on paper the business has earned a higher figure than what is in the bank account. This could be because of a slow paying customer. Therefore sole traders often complain that they are being taxed at high rates when they haven’t seen the money. With a Limited Company this situation would be different.
3) Treatment of cars for tax
One thing that often goes in the favour of a sole trader is the tax treatment of cars. If you use a car in your business then you can claim a percentage of the costs though a sole trade business. Don’t forget that you can also claim a percentage of capital allowances which should be included on your tax return. If a car is owned by a Limited Company and used personally by you, (commuting is considered personal), then there can be a hefty benefit in kind charge. Therefore it is often worth claiming mileage from the Limited Company instead.
However, this does need to be weighed up carefully when considering if you should be a sole trader or Limited Company because every situation is different, including car efficiency and the allowances you can claim.
4) More tax savings
If carefully planned there can be more tax savings in addition to what is outlined above. This could be at the point of converting to a Limited company, closing the Limited Company, or somewhere in-between. As an accountant and tax advisor I would be able to help identify if this is a possibility for you. A review is best done before you convert, however, it still has merit if done afterwards.
5) When tax is paid
If you are an employee, (including employee of your own Limited company), then you pay it straight away through your payslip. If you are a sole trader then you pay in July and January, but you also have to pay estimated tax in advance. A Limited Company pays tax nine months after the year end, so from a cash flow perspective it is better, but you should ensure you save towards it.
6) Drawing your income
For a sole trader that is simple, the money in the business bank account is effectively yours anyway. For a Limited Company it depends how you structure it. Most people pay a combination of a salary and dividends, both come with different tax implications, but dividends have no national insurance charged. It is worth discussing this with your accountant as there are some stringent tax rules about taking dividends, which if not done correctly can leave you owing an additional 25% in tax.
I have seen many occasions where accountants have not explained this properly, or even not explained it at all. So be careful, especially if you hear the phrase overdrawn loan account, or that you have not saved enough for company tax.
7) Personal mortgages
It is worth bearing in mind that if you need a personal mortgage on your own home then when you convert to a Limited Company the bank will view this as a change in jobs. Therefore when filling out mortgage applications they normally ignore your past trading history as a sole trader. So as a word of warning, make sure you are happy with your current mortgage deal for the next three years before you go Limited.
8) Limited Liability status
If you are a sole trader then your personal assets are not separated from your business activities. Therefore, if someone were to sue your business, or your business had debts which it cannot repay, then you are personally liable. This means you may be forced to sell personal assets, such as your home, if you cannot pay the business debt. Some people choose a Limited company for this fact alone, especially if they have staff which make decisions in their business.
9) Credit ratings
As the Limited company is separate to you as a person you will both have a credit rating. If the Limited Company has not been trading for very long then the rating is likely to be set at a pretty average level. This can hinder the company from getting loans in the first few years, and can change the terms that suppliers are willing to offer. Their concern is if the business cannot repay debts then they cannot ask the individual to pay, (unless there is a personal guarantee in place). We are able to review your companies credit rating and discuss it with you, and give you suggestions about how to improve it.
10) Are you allowed to operate through a Limited Company?
Most of the time the answer to this is yes, trading businesses can operate as a Limited company. Quite a few years ago regulations changed which means the majority of Limited Companies in the UK do not need an audit either. However, there is a tax regulation called IR35 which needs to be considered first.
Your accountant should have already discussed this with you as there are some situations where you are not allowed to declare your income to the tax authorities through a company. There is a test you can do which is on HMRC’s website, but there are also some considerations which conveniently for them they exclude. IR35 normally catches contractors out if the contract looks and smells as though it is contracting a person rather than a company. For some, this can be quite a detailed area that your accountant or lawyer needs to review with you.