What are the tax implications of becoming a limited company?

Published by Michael O’Brien on 12 August 2015

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Question: I am currently running my business as a sole trader business but I am looking to convert it to a limited company. What tax implications would this have?

Answer: The tax implications and potential advantages of incorporation vary depending on a number factors such as the size of business, the length of time that the business has been in operation (for a loss making sole trade business), its profitability and its expected rate of growth etc. For example, a business with small profits, incorporation may look attractive.

This is because, for a sole trader, its taxable profits are subject to income tax at the appropriate rates of 20%, 40% and 45%, depending on the level of profits generated in an accounting period and other sources of income that the individual may have within a tax year.

In addition, the individual is also liable to pay National Insurance Contributions (“NICs”) on the taxable profits, regardless of whether the individual draws cash from the business or not.

Individuals are also required to make two tax payments on account to HM Revenue and Customs every year when its tax and NICs liability exceeds £1,000. If the business is loss making, then incorporation may not be a good option, as there are loss relief implications to consider.

However, when the sole trade business is incorporated, the company’s profits will be taxed at a lower corporation tax rate at 20% (which is due to be reduced to 19% in 2017 and 18% in 2020) and NICs are not levied on the company’s profit.

The company tax payment is due nine months and 1 day after its accounting reference date and it is not required to make payments on account as sole traders are required to (unless its profits exceed £1.5m).

Providing the sole trader becomes a shareholder/director of the new company, profits extracted from the company by way of salary and/or dividends will be taxed in the hand of the individual at the appropriate income tax rates.

At present, dividends paid by a company to a shareholder are tax free while that individual is not a higher rate tax payer. However, this will change from April 2016 where only the first £5,000 will be tax free and the rest will be taxed at new dividend tax rates of 7.5%, 32.5% and 38.1% accordingly – no NICs are payable on dividends.

If carefully planned, income tax and NICs on salaries and dividends could be kept at the lowest level, hence minimising overall tax liabilities.

There are also other means of saving corporation tax such as approved making contributions to pension schemes and undertaking capital investment.

Operating through a company gives the owner/manager much more flexibility in how they get remunerated and so provides greater opportunity for effective and efficient tax planning.

Looking specifically now at incorporating a sole trade; normally, when an individual disposes of business assets, there are capital gain tax implications.

However, Incorporation relief and Gift relief may be available to defer or minimise such tax charges. Incorporation relief is available if all business assets, including the business goodwill but excluding cash are transferred to the new limited company. Gift relief may be available where the sole trader gifts assets into the company and undertakes a joint election.

A valuation of the business would need to be undertaken by a professional valuer and you would need to obtain HMRC’s clearance. This is a complex area (certainly too complex for this platform), and hence a professional advice is recommended.

While incorporation may bring many tax advantages, unfortunately there are also potential disadvantages, such as additional annual administrative costs involved with operating a limited company over a sole trade.

The company is required to submit its Annual Accounts to the Companies House to comply with the requirement of the 2006 Companies Act as well as additional company secretarial compliance matters such as annual returns, keeping statutory books and records, company minutes, etc.

There are other benefits of incorporation in addition to tax efficiencies. From a commercial perspective there is a market perception that limited companies are more established and “bigger” than their sole trader counterparts, which could benefit the business in attracting customers and employees.

Also a significant benefit of operating through a company is “limited liability” which means that if the company does not succeed then the shareholders liability is restricted to just the investment made in the company as the limited company is a separate legal entity from the owner.

As a sole trader however the business and its owner are the same legal entity and therefore if the business fails or has legal proceedings placed on it then potentially the sole trader could have unlimited personal liability on behalf of the business.

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