Business Owner Advice: Deciding whether to operate as a sole trader, partnership or limited company

For most new and existing businesses there is a decision whether to operate as a sole trader or – if in business with others – a partnership, or form a limited company.

The recent increases in the tax rates on dividends have led to more owner-managers considering which option works best for them.

Dividends for a limited company

Prior to April 2016, dividends were taxed at 0%, 25% and 30.6% according to whether the business owner was a basic, higher or additional rate taxpayer. After this date, there was an increase of 7.5% across the board, with a small grace of £5,000 being tax-free.

This tax on dividends is levied after the company has suffered 20% corporation tax (though this is scheduled to fall to 17% over the coming years). This means that as it stands, the effective rate of tax for owner-managers is now:

Tax bracket

Effective rate of tax

Basic

26%

Higher

46%

Additional

50.5%

Sole trader/partnership

The comparative rates for sole traders and partnerships are 20%, 40% and 45% which appear to come up trumps, but while dividends are free of national insurance, unincorporated business’ profits attract the tax, starting at 9% on amounts similar to the basic rate threshold, then 2% thereafter.

It’s clear that the government aim to close the gap in tax rates between the employed, self-employed and company directors.

Tax benefit

The tax benefit has been largely eroded, where the fiscal benefit of operating through a company is confined to those with profits between £50,000 and £150,000, aside from a flip in the £90-110,000 bracket.

When you factor in increased accountancy fees (it’s more work – honestly!) for a company, and a great admin burden; is it really worth it?

The numbers…

The table below shows an example of the difference in net earnings after tax under the different models. The method by which profits are arrived at differs in the different structures, but for the purposes of comparison the same profit figures is used as a base in these workings.

Profits

Limited company

Self-employed

£10,000

£8,000

£9,680

£40,000

£30,800

£31,180

£50,000

£38,200

£37,370

£140,000

£85,600

£85,170

£150,000

£89,700

£90,970

£200,000

£115,535

£117,470

 

Other important factors

There are 5 other important factors to consider when deciding on whether to operate as a sole trader, a partnership or a limited company.

1.      Limited Liability

A company is a separate legal person, which means limited liability for the shareholders. For sole traders or partners, they trade in their own name, which means exposure to personal assets and reputation. An alternative structure, a Limited Liability Partnership (LLP) recreates the corporate protection while keeping the features of a partnership.

2.      Flexibility of managing the tax charge

And for all the talk about tax savings, with a company, you only pay tax on dividends when they’re extracted from the company, giving the discretion retain profits in the business and not be taxed on them. These accumulated profits may then be paid out in a tax efficient way with careful planning when retiring or selling the business. Compare this to an unincorporated business, where tax is paid as profits are earned.

3.      Package of earnings

The flexibility also extends to how profits are treated. As mentioned, for individuals and partnerships trading, tax and NI is levied straight on the profits. On top of being able to manage the distribution of profits to curb the tax charge, the director of a company can combine a tax-efficient mix of salary, dividends and pension contributions.

4.      Public impression

To the outside world, a corporate face to a business can create a more professional, credible image. With a company, annual filings to go on public record at Companies House are necessary on who runs the company, who owns it and its financial position, which might leave some feeling uneasy, but recent changes mean disclosures are greatly reduced and much still remains private.

5.      Other tax breaks

Further to the tax benefit cause, certain reliefs are only available to companies, such as for R&D, the patent box tax rate and Enterprise Investment Scheme reliefs.

Summary

Ultimately, the decision of whether a limited company or whether to operate as a sole trader/partnership will go further than what the current tax rates indicate as the winner. The riskiness of their trade, their attitude to privacy and approach to admin will play as important a part.

Next steps…

If you are thinking of starting a business, or want to make sure the one you currently operate is set up in the best fashion for you, contact ICS for a non-obligation chat by completing the short form below or visit our Contact Us Page.

This article was written by Sam Price of ICS Accounting, who has a wealth of experience in accountancy for small and medium-sized businesses – contact Sam via Linkedin or at sam.price@icsuk.com.