Friday, 1 March 2013

Changing from a sole trader to a limited company

There are advantages for some businesses in operating as a sole trader. The main benefit is that it is simple to set up and administer. There is a requirement to notify HM Revenue & Customs within 3 months of commencing trade. In terms of administration ‘Class 2’ National Insurance will need to be paid monthly or quarterly and a self assessment tax return will need to be submitted every year. Many sole traders deal with their own record keeping and enlist the help of an accountant to compile year end accounts, deal with the tax calculations and file the tax return. Accountancy costs are therefore relatively low. So simplicity and low administration costs are the main benefits.

Once a business reaches a certain scale there can be a case for changing the status of the business to a limited company. An advantage of a limited company is that the shareholders are only liable for the value of their shareholding (which may just be a nominal sum) if the business gets into financial difficulty. Sole traders are personally liable for any debts the business incurs. There can also be greater credibility from operating as a limited company and under current UK tax rules there can often be savings from trading via limited company in comparison to being taxed as a sole trader.

A sole trader is taxed on the profits of the business. There is no separation between the business and the individual so in a good year personal taxation will be high and the converse in a bad year. The company is a separate entity from its shareholders and is taxed on its profits. Company tax rates in the UK are relatively low at 20% for the smallest companies. Shareholders and directors (who are often the same people) are then taxed on the income they draw from the company as dividend or salary. As there is flexibility on how much and in what mix this income is drawn, it is often possible to keep personal tax levels low.

An analysis by a firm of chartered accountants looked at typical net tax savings from operating as a limited company in comparison to a sole trader. For profits of £50,000 per annum, potential tax savings are in the region of £4,000 per annum. Tax rules can change of course so trading a company solely for tax reasons is probably not a good idea. The administration costs of a company are higher than for a sole trade business. Company accounts need to follow stricter guidelines and typically a company will need to administer payroll and dividends and maintain more detailed records.

Once the potential transferor has weighed up the pros and cons, changing from a sole trade status to a company is reasonably straightforward. It needs careful advance planning as the new company will need to be formed, customers and suppliers advised, contracts changed etc ahead of the transfer date. There can be tax benefits from the transfer itself with the new company effectively purchasing the sole trade business from the proprietor. No funds need to change hands at the handover date but the purchase consideration is usually set up as a director’s loan which can be drawn on over a period of time. This can be a useful top up fund to draw on top of salaries and dividends tax effectively. There are other tax implications to consider for the transferor including capital gains tax. Overall though, if structured in the right way there can be significant one off and ongoing savings for the transferor and the new company from changing the business status in this way.

I would recommend sole trade businesses with annual profits in excess of £50,000 or businesses that have ambitious growth plans to give consideration to changing their status to a limited company. They may be surprised at the potential benefits and with professional support and a little effort it can be implemented fairly quickly and painlessly.