Limited Company 'v' Sole Trader - the tax comparison

Minimising the overall 'tax leakage' is a key aim for all businesses. Despite the Chancellor's four attempts to increase the corporation tax assessed on SME limited companies, the tax benefits of trading through a limited company still remain attractive for businesses with modest profits.

The basis of taxing small company profits over recent years:

Up to 31 Mar 00 - Profits up to £300,000 taxed @ 19%

1 Apr 00 to 31 Mar 02 - First £10,000 profits taxed @ 10%

1 Apr 02 to 31 Mar 04 - First £10,000 profits taxed @ 0%

1 Apr 04 to 31 Mar 06 - Profits extracted as dividends taxed @19%

1 Apr 06 to 31 Mar 07 - Profits up to £300,000 taxed @19%

1 Apr 07 to 31 Mar 08 - Profits up to £300,000 taxed @20%

1 Apr 08 to 31 Mar 11 - Profits up to £300,000 taxed @21%

From 1 Apr 11 - Profits up to £300,000 taxed @20%

As the illustration below highlights, based on the UK tax rates and thresholds for 2012/13, the corporate medium still results in the lower overall tax charge (allowing for the extra accountancy fees incurred through trading as a limited company), whilst profits exceed, approximately, £13,000 pa:

Note

In the above comparison it is assumed company profits are extracted first by a salary of £7,485, with the remainder drawn as dividends. It is also assumed in both mediums that the proprietor receives no other personal taxable income and that there are no associated companies.

As well as the amount of direct taxation due on profits, businesses should consider a number of further issues before deciding which of the two trading mediums is most appropriate:

• Other tax matters:
  • IR35 issues,
  • The ability to extract or retain profits in a different manner and the use of other family members' tax allowances and reliefs (subject to section 660 settlement legislation rules),
  • Timing of tax payments,
  • The profit or loss profile of the business over time (particularly with regard to use of losses and lower early year profits),
  • The tax costs of running a car, that is also used privately, within the business,
  • The more generous corporation tax deduction regime for purchased goodwill, research and development costs, private use of mobile phones and recovery of sub-contractor CIS deductions,
  • The tax and timing aspects of 'exit routes', including gains on substantial shareholdings,
  • For unincorporated businesses converting into a limited company, the ability to crystallise the goodwill of the business and extract this tax free from the new company. For many businesses, this can be used to avoid paying higher rate income tax for a period after the incorporation. This can also assist with lowering your taxable personal income and hence improving entitlement to Child Tax Credit,
  • Future, further unforeseen changes in tax rules.
• Commercial matters:
  • Protection, to 'ring fence':
  • Trade litigation,
  • Onerous contracts (including leases for property, royalty agreements, photocopiers, etc),
  • Insolvency (particularly relevant during recessionary times),
  • Employment right costs (notice pay, redundancy & tribunal awards),
  • Health & Safety,
  • The importance of keeping financial results and other business information confidential (although the use of our address as Registered Office and directors' services address, plus filing minimum disclosure abbreviated accounts on the public record at Companies House, can help with this),
  • Image and credibility in the marketplace (including when seeking credit from a new supplier),
  • Avoiding the situation that might arise where a client refuses to engage consultancy sercives from a sole trader (to minimise their risk of a claim from HMRC that such an arrangement was 'disguised employment'),
• Cost and practical matters:
  • The possible need for a statutory audit, if turnover exceeds £6.5m,
  • The additional paperwork, other administration work and professional fees (startup, ongoing and exit) associated with trading as a limited company and, in particular, how far ahead you can predict the business has a profitable future,
  • Keeping personal finances separate from company finances (including the additional management involved in calculating and transacting permissible dividends, compared to drawings),
  • Pension and personal mortgage issues,
  • Motor and General insurance considerations,
  • For retail businesses, the level of Business Rates that will be assessed,
  • Credit rating,
  • Use of certain words (eg Group) in the company.

• How long into the future that you believe the business will continue to trade.

The decision of which trading medium to trade through should be based on many factors, and will usually require professional guidance. If minimising the taxation on profits is a key concern, and these profits are modest, trading as a private limited company, as opposed to being a sole trader or partnership, is still an attractive option.

Note

When reviewing the above alternatives, consideration should also be given to Limited Liability Partnerships.

Other Practical Examples of our Tax Planning Expertise

Minimising the tax cost of operating a vehicle for both business and private useage. Self administered pensions as onshore tax havens for owning commercial property.

Advising on salary sacrifice and employer funded pension contributions. Convincing HM Revenue & Customs that outstanding tax should be waived when it originates from their PAYE coding errors/delays.