March 30, 2016 Differences of Sole Trader vs Limited Company 16/17 What are the key advantages and disadvantages of trading as a self employed sole trader vs limited company for the 2016/17 tax year? Making the decision as to which structure your business operates as can be crucial, whether that be in terms of tax savings, perception to the outside world, keeping things simple or future plans you may have. In this article we will review the main differences between trading as a sole trader / self employed or limited company in terms of the tax consequences, administration and other non-financial aspects with regards to the 2016/17 tax year. As we outline further in the article, there has been a major change to how dividends are taxed from 6th April 2016 which is a key factor in the comparison between a sole trader and a limited company. UPDATE – we now have a new updated article on the same topic for the 2017/18 tax year which can be found HERE. Our advice in this article about the topic of sole trader or limited company is geared towards freelancers, contractors and modern small business owners as that is our area of expertise. Tax Due to the changes in dividend taxation for 2016/17 there is a narrowing of the tax advantages that trading as a limited company offers over a sole trader. As such, for the 2016/17 tax year at least, the tax saving of a limited company are not as large and at some levels of profitability are not sufficient in isolation to make the decision clear-cut. Our tax comparisons assume a simple position where the only income being earned by a person is either their sole trader income or their salary and dividends from their limited company i.e. there is no other personal income to consider such as rental income. As a sole trader an individual must pay tax on all profits over and above their personal allowance, for most tax payers the personal allowance is £11,000 for the 2016/17 tax year. Once the personal allowance has been breached tax is paid at the rate of 20% in the basic rate of tax (up to £43,000 income), 40% as a higher rate taxpayer (over £43,000) and 45% in the additional rate band (over £150,000 income). There are also further personal tax issues to consider such as child benefit starts to be withdrawn once your income goes over £50k and the personal allowance begins to be withdrawn once your income is over £100k. As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4. A limited company, on the other hand, pays corporation tax on profits at a current rate of 20%, over and above this there can be personal tax to be paid with regard to dividend extractions from the business by the owner/director. In order for the extractions to be as tax efficient as possible the director normally would draw a small salary from the company within their personal allowance but not above the point at where national insurance becomes payable, this salary would be an allowable business cost for corporation tax so 20% corporation tax is saved on the salary. The remainder of their withdrawals would be in the form of dividends, these are paid out of post-tax profits and are not deductible expenses for corporation tax purposes so offer no tax saving, however there is no national insurance to pay on dividends. You can read our article about the optimum limited company salary and dividend levels for 16/17. From 6th April 2016 Dividends are taxed at 7.5% in the basic rate of tax, with rates of 32.5% & 38.1% in higher and additional rates respectively. The first £5,000 of dividends that would otherwise be taxable at the above rates are currently subject to a tax free allowance (called the ‘dividend allowance’). There is no requirement for the owner to withdraw all profits from the business if they are not personally needed, and indeed it can prove tax efficient to leave profits retained in the company for extraction at a later date or to re-invest in the company (e.g. to invest in equipment or staff). In the table below we outline the tax savings of a limited company compared to a sole trader for different levels of profits based on the 16/17 tax year. We have assumed an optimum level of salary and dividends in the scenario of a limited company and the figures include national insurance payable as a sole trader. The profits are on a like-for-like basis so do not include salary for the limited company. Tax differences of a sole trader vs limited company for 16/17: So for example looking at this table, comparing the tax rates on sole trader or limited company, you can see that for profits of £40,000 the tax and NI for a sole trader totals £8.8k compared to the combined tax of a limited company (corporation tax on profits and income tax on dividends) totalling £7.7k, so there is a £1.1k saving by using a limited company. The above table shows that where all profits are withdrawn from the limited company the savings do not continue to increase as profits rise past £60,000, the optimum level in this scenario is approx. £52,000. Whilst there are tax savings at all levels of profitability the extra administration costs (discussed further in this article) can exceed the tax benefits at lower profit levels. Do you need all the profits? One really important point worth considering is the tax savings where the business owner retains post-tax profits within the limited company. A sole trader has to pay tax on the profits whether the money is required to be drawn personally or not. However a limited company may choose to not pay out all the post-tax profits as dividends (perhaps they want to build up profits in the company for further down the line, or they might want to hold back some of the profits to invest in equipment or staff for example). As an example of this, imagine a sole trader with profits of £60k. They will pay tax and NI of £16.8k. However if they were a limited company and they could afford to retain £20k of the post tax profits in the business (i.e. they leave £20k of the dividends they could have taken out in the company) then their combined corporation tax and personal tax would total £11.4k, which gives a tax saving of £5.4k. The difference is so large because the sole trader is in the higher tax band and paying 40% of any profits above £43k whether they need that cash or not. This is an example of where a limited company structure can offer much more flexibility on the timings of drawing down cash and the associated tax charges. This can also be useful for contractors who might want to build up cash in their company so they can take a break from contracting but still continue to draw down dividends. It can also be useful for cyclical businesses that have a couple of strong years but expect a couple of tougher years also as they can smooth their dividends over the years (assuming sufficient post tax profits overall to support the dividends). Expenses There are subtle differences in the types of costs that are allowable for tax purposes and the way they can be claimed between the two types of entity, self employed or limited company. As a director of a limited company you are considered an employee therefore can access a range of tax free benefits and perks. One of the most common of these is being provided with a mobile phone or a computer. So long as there is some business use these items can be provided tax free. As a sole trader you would need to add back to profits any private use element of any type of equipment. We have written a guide outlining some common sole trader expenses. It should be considered that in both types of business structure expenses claimed need to be wholly and exclusively for the purposes of the trade of the business. One of the most beneficial tax difference of allowable expenses is in regard to pension contributions. As a sole trader you can gain tax relief on payments into a pension but these amounts can be fairly restricted dependent upon your level of income. For an individual where income is below the higher rate tax threshold there is a tax benefit but this is added to your pension contribution by way of grossing up the contribution and the tax benefit is currently somewhat hidden in the current year as it sits in your pension fund. As a director the amounts can be far more generous, the company may pay a contribution into your pension of up to £40,000 per tax year (based on 16/17) and more in some cases where there has been little by way of pension contributions in the preceding years. Company pension contributions on the whole will usually also be an allowable cost for corporation tax purposes (HMRC look at the combination of salary and company pension contributions to ensure the total ‘remuneration’ is not excessive). Disclosure : we would always recommend discussing pensions with a pensions advisor before making any decisions as there are various rules and details to be aware of. The discussions above are in regard to the 16/17 tax year and the 20% corporation tax rate that prevails. Going forwards the rate is planned to decrease to 19% in the next financial year with proposals in place to reduce this rate further still to 17% by 2020. At a rate of 17%, with all other variables remaining equal, the annual tax saving of incorporating a business at all profitability levels becomes even more beneficial. Another thing to consider is that if you are married then there may be the opportunity to give your spouse some of your shares so that they can receive some of the dividends – however this is something that should be discussed in detail with an accountant. Administration Of the two business structures, operating as a sole trader has the advantage of simplicity. When setting up you simply need to contact HMRC and register for self-assessment. Every year that you are self employed you will be required to file a self-assessment tax return and pay any tax due by the 31st January following the end of the tax year in question. For example, for the 2016/17 tax year (6th April 2016 to 5th April 2017) the tax return and tax payment is due to HMRC by 31st January 2018. On the tax return you will need to declare your sole trader income and expenditure, in some cases where your annual sales are below the VAT threshold (£83,000 for the 2016/17 tax year) you are simply able to report three figures on the return – being total sales, total expenditure and the profit made. Your tax return will also need to declare any further income received from other sources. You don’t need a fancy book-keeping system, often a simple spreadsheet will be fine. Trading as a Limited Company is generally more complicated. Initially you need to check if the company name is available as two separate companies cannot trade with the same name or names that are too similar. Once you are comfortable with the name you must register this with Companies House who will provide an incorporation certificate showing the company number and confirming the company is now a legal entity. A limited company has shareholders, who own the company, and the shareholders appoint directors to run the company on their behalf. The two positions are often held by the same people but it’s important to understand the differences. Dividends are paid to shareholders, and salaries are paid to the directors. As a limited company the business is more traceable as details of the company directors and shareholdings are held on public record. The company will also be required to have a registered office address which is often the premises from which the company does business. Where this is considered not suitable there is scope to use a different address as a registered office and some companies choose to pay a small fee to use a central London address for example. As a director of a limited company you have certain legal duties that must be fulfilled in order to comply with the companies act. These include, but are not restricted to: Maintaining full & accurate accounting records Prepare and filing of annual accounts with companies house Filing of an annual return, detailing the details of directors and shareholdings etc. Ensuring that the company complies with relevant tax and employment law A limited company is usually required to file its full accounts and corporation tax returns with HMRC and abbreviated accounts with Companies House, as well as an annual return with Companies House. The corporation tax is usually due for payment within 9 months of the companies year end. In most cases the directors of a company will need the assistance of an accountant. A good accountant will ensure that the required documents are filed on time and also that the company is maximising its tax efficiency in regard to extractions by the directors/shareholders. As a rough guide the extra accounting fee costs are likely to be in the region of £1,000 per year more for a simple limited company compared to that of a sole trader (assuming a simple small business, freelancer or contractor). Other benefits of limited company There are a number of non-financial benefits that exist as a result of trading as a limited company. Possibly the most significant is that of limited liability status. Limited liability status was first fully established in the 1890’s when the House of Lords upheld that a company had its own legal personality. This ruling ensured that creditors of an insolvent company could not sue the individual shareholders for money that was owing to them. This rule of law still holds true today and as such incorporation can prove extremely useful in protecting private assets. In the event of a limited company incurring an unforeseen liability (such as a legal claim) in most cases this liability will be limited to the assets owned in the name of the company. The directors do need to be careful with regard to personal guarantees and the potential for wrongful trading (e.g. continuing to acquire credit which the company has little chance of servicing), in these instances they can become personally liable. For a sole trader there is no such distinction between personal and business assets as the business and the individual have no separate legal status. Therefore personal assets such as the family home could be at risk, certainly where the business operates in a fairly litigious or highly sensitive sector. This risk can be somewhat covered off by having sufficient insurance policies in place. The perception of a business can be altered dependent upon the trading vehicle it operates from. Simply by trading as a limited company a reputation can be enhanced as it can give the potential customer a sense of permanence and credibility which a sole trader cannot. In some circumstances (certainly for some contractors) clients may not be willing to engage unless the business is operating as a limited company. In certain business sectors where external investment may be required a limited company offers an advantage in that outside investors can easily be offered shares in the company in return for their cash injection. The offering of shares through share based-schemes can also prove particularly useful in obtaining and retaining talented staff or directors in a business. IR35 It’s important to be aware of IR35 which is legislation around employment status when you trade through a limited company. We have a detailed IR35 guide, but if you are concerned that there is a risk that you may be caught by IR35 and could potentially be seen by HMRC to be an employee of your client then being a sole trader could be a better route, if the client allows. Summary You can see from this article that choosing between a sole trader or limited company involves many tax and non-tax issues. Overall, trading as a limited company can offer benefits of both security and tax advantages at certain profitability levels, however every business is different and a one size fits all approach is not suitable, particularly given the recent changes to the taxation of dividends. We strongly recommend that if you are considering a sole trader vs limited company that you seek the advice of an experienced and qualified accountant to advise you on your specific circumstances.