Company bonus, or sole survivor?

Does limited liability appeal, or would you find yourself better off going it alone? John Whiting answers a taxing question

Sooner or later, anyone starting out in business has a key choice to make in terms of the way the business is carried out: the business medium. Do you want to trade as a sole trader, a partnership or a company? There are major practical implications, and also significant tax consequences, which have been given an extra twist by the last Budget.

CHOICES, CHOICES

The basic decision is whether to be a company or not. Setting up a limited company means you have a separate entity to manage. Technically it could be unlimited, but let's leave that to one side. Staying unincorporated is simpler: you just carry on as you are, on your own or as a partnership.

Recently a "third way" has appeared. This new kid on the block is the "Limited Liability Partnership" (LLP), which, as the name suggests, combines features of company and partnership.

COMPARING THE POSSIBILITIES

The unincorporated route offers simplicity and informality, though a partnership should have a partnership deed to regulate itself. Problems might be unlimited liability and difficulty in retaining funds in the business for working capital: all profits accrue to the owners and are taxed.

The company route offers the chance to retain profits, paying dividends as appropriate. Limited liability is there, but often the owner/director(s) will have to provide personal guarantees, for instance to banks, which cut across limited liability. The great joy of limited liability is that if things go wrong, creditors can usually only pursue the company for repayment, not you individually. However, a company involves a certain amount of paperwork.

It's a case of weighing the factors and making an informed choice. One factor can be the intangible, emotive one: do you want to be a company? And are you operating in a sector in which being a company can reassure clients and customers about your permanence and solidity? Or would they feel better if they were, in effect, dealing directly with you?

TAX CONSEQUENCES

Companies and unincorporated businesses are taxed differently. With all profits of the unincorporated business facing income tax at rates of up to 40 per cent, corporation tax looks a good alternative with a top rate of 30 per cent, and that only coming into play when profits reach £1.5m a year. The new twist with this year's Budget is nil corporation tax for profits up to £10,000. So is this a push towards the corporate route?

National Insurance Contributions (NICs) must be factored in. The self-employed pay less in NICs than the employed, though the difference is not huge. The major difference is employers' contributions. If you operate through a company you can pay yourself a salary, which means the company pays 11.8 per cent NICs on the slice of your salary above the £4,615 personal allowance level.

There are no NICs on dividends and so if the company pays a dividend, the NIC "hit" is mitigated. There will be more income tax to pay for a higher-rate taxpayer. The snag with this tactic is the (in)famous IR35 rules. If, without the "wrapper" of the company, the owner would be regarded for tax purposes as an employee of a client to which the company sells the proprietor's service, in essence these fees have to be taxed as if they had been paid to an employee. In other words, the personal service company, the real target of IR35, has to operate PAYE and employer/employee NICs.

Any thinking on the business medium has to factor in the spectre of IR35. There are other tax issues as well. For example, the impact of a capital gains tax charge on any assets the business might own. Then pensions contributions must be borne in mind. The company route may offer some scope for a separate pension fund, but these days most people will be thinking about personal or stakeholder pensions.

An interesting change here is that whereas in the past you had to have earnings – a company salary or unincorporated business profits – to be able to get tax relief for pension contributions, this isn't necessarily the case nowadays. Since the advent of the stakeholder rules, having earnings in one year can "drive" contributions for the next five years. So where the company once would have had to pay out salaries and walk into those employer NICs, it's now possible to fund pension contributions tax-efficiently with dividends and the occasional salary.

DOING THE NUMBERS

I don't think there is a level of profits at which one can say, "you must incorporate". It's a case of balancing all the factors, including those tax differences I mentioned earlier (assuming IR35 is not a factor).

EXAMPLE 1

Fred has profits of £50,000. If he operates as a sole trader, he pays income tax and NICs of £14,452.

Operating through Fred Ltd, if Fred pays himself a salary of £36,265, that will leave a profit of £10,000 after employers' NICs. There will be no corporation tax for the company, so the overall tax bill will be £13,362, with £10,000 sitting in the company.

Taking it a bit further, Fred could pay himself a salary of £10,000, have Fred Ltd pay him a dividend of £20,000 and end up with an overall tax bill of £9,101 and £12,391 retained profits in the company.

Example 1 shows that significant tax differences are possible, more than enough to cover the cost of running the company. Fred still has some monies left in the company, which may suffer tax in some ways when extracted. But coming down the income scale, interesting tax differences are now possible, as Example 2 shows.

EXAMPLE 2

Freda's income is £15,000. As a sole trader, she will have income tax and NIC of £2,885. But operating through Freda Ltd, she could pay herself a salary of just under £5,000; that would attract a few pounds of NICs, to keep her contributions record firmly up, and a little income tax. Freda Ltd's profit of £10,000 would attract no corporation tax and could be paid to Freda by way of dividend tax-free.

CONCLUSION

The incorporation decision is not one to be rushed or taken just on tax grounds: there are lots of other considerations. But the reduction in corporation tax rates for low profit levels makes the company route a serious contender for small businesses that previously wouldn't have considered the extra hassle of a company worthwhile. Tax savings are potentially sufficient to cover the costs of running the company. Just don't forget that the company does have to be run, and that the company's monies are not automatically yours. To paraphrase that well-known saying, a company isn't just for Christmas, it's for life!

John Whiting is a tax partner with PricewaterhouseCoopers and immediate Past President of the Chartered Institute of Taxation