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The number of people incorporating has risen fast in recent years, primarily to cut their tax liability. But incorporation is a serious business consideration beyond the obvious tax savings.
The labour market has radically changed since the turn of the millennium. Self-employed people now make up more than 15% of all people in work – that’s almost five million, a 45% jump since 2000.
A decade ago, there was a clear tax incentive to move from sole trader to incorporated status. But in light of the rise in the number of self-employed, the government has in recent years reduced the difference in tax benefits between the two statuses to deter those using incorporation simply to reduce their tax bill.
There remain tax advantages to incorporation, but they are fewer. Nonetheless, the question of whether to incorporate remains a valid one for many people. It’s important to consider all of the costs and implications before setting up your own company. These are some of the pros and cons.
Many sole traders who set up a company do so for reasons of tax efficiency. As a company you can pay yourself a salary and any profits on top will be taxed at the corporate tax rate of 19%.
On top of a salary you can pay directors dividends. Currently, dividend income above the £5,000 threshold is taxed at between at 7.5% and 38.1%, depending on an individual’s tax rate. And National Insurance contributions are not payable on dividends.
However, Philip Hammond announced in March’s Spring Budget that from 6 April 2018 the tax-free dividend allowance would fall to £2,000 in a bid to “address the unfairness around director/shareholders’ tax advantage”.
“The benefits were a lot better. The government has clamped down recently but it’s still beneficial,” – Lee Murphy – founded and runs cloud bookkeeping software company Pandle.
There is some relief elsewhere, however. As a director of a company you can claim tax relief on business expenses as long as they are incurred wholly, exclusively and necessarily in the running of your company.
“The traditional tax advantage has somewhat disappeared. Unless you have profits over £30,000 then there’s very little tax advantage anymore,” says Elaine Clark, managing director of CheapAccounting.co.uk.
Many choose to incorporate because of the limited liability. As a sole trader, you and your business are viewed as the same legal entity so you are personally liable. With a limited company, your risk is reduced because the company is a separate legal entity.
“One of the main reasons people move to a limited company is the protection, particularly if you operate on your own or have a house. I still think this is very important and shouldn’t be overlooked,” Clark says.
With limited liability, if a company were to get into trouble, a director’s personal assets would be protected, but many view this advantage for the long term.
Martin Atkins, a partner at accountancy firm Menzies, adds:
Others have ambitions and want to grow a sustainable business that will support the employment of others and that they can sell or pass to the next generation. They are happy to invest in a structure in the short term, for potential long-term gains. These individuals will view incorporation as a means of establishing the business on firm foundations, while minimising the risk of financial liabilities.
Raising your profile
Incorporation can convey an impression of respectability and professionalism to suppliers, employees and clients. With more clearly defined structure and legal responsibilities, a company can be viewed as more dependable because more is at stake.
“There’s a perspective that a company is bigger so it adds status,” Murphy says.
Investment is likely to be easier to obtain as a limited company. However, banks may require directors to give personal guarantees, which impacts on the limited-liability advantage.
“One of the main reasons people move to a limited company is the protection. I think this is very important and shouldn’t be overlooked” – Elaine Clark, managing director, CheapAccounting.co.uk
If you want to sell your business, being incorporated should make it easier too. Investors and buyers tend to prefer incorporated companies, as the paperwork is typically accurate and in order.
“I was looking to scale the business in the next few years and limited liability gives me that confidence. It’s about challenging myself to be bold about what I wanted to achieve out of the business,” says Mark Hamill, who sought advice from Menzies to set up his business The Naked Headhunter this summer.
“We are ahead of where I expected to be in the first nine months,” he says.
Responsibilities and paperwork
Responsibilities increase significantly as a company director. As a director, you must adhere to more compliance by maintaining rigorous bookkeeping; producing statutory accounts, which must be filed at Companies House; and submitting tax returns.
It’s worth noting that fines for late payment or late returns are bigger, too.
Many people aren’t aware of what’s involved in the basics of setting up a company. With incorporation, there’s a lot more administration to do right from the start as concerns straightforward things such as opening a business bank account.
Returns are more complex, with more regulatory requirements than you are subject to as a sole trader. The CS01 confirmation statement, which became effective in 2016, is another new form you’ll need to complete and submit yearly.
More paperwork means greater costs too. For microbusinesses, this should be a major consideration. Accountancy fees can increase as well.
With greater responsibility, there is also greater visibility. This one can fall into both positive and negative categories depending on your view. The increased visibility is great for potential clients, who can check out your credibility because you’ll be on a public register at Companies House. Your balance sheet will be publicly available as well.
Martin Atkins says:
Weigh up the decision carefully and get professional advice. It’s important to be aware of the potential risks, particularly if opting for sole trader status.
Regardless of whether you choose to operate as a sole trader or get incorporated, it’s important to research the target market carefully and put in place a pricing and cost structure that will be profitable. It’s also important to consider the ongoing costs and responsibilities that come with incorporation.
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