You’ve made that first important step and committed to starting a business working for yourself. You’ve done your market research, created a business plan, got the initial funds together, maybe even have a few clients already lined up. Now you have to make a key decision: whether to operate as a sole trader or a limited company.
Perhaps the key benefit to operating through a limited company, is limited liability. As a sole trader, if you or a customer has an accident or loses money, you can become personally liable. A company is a legal entity in its own right so it is liable for its own claims.
On the flip side however, a limited company has more administrative responsibilities and its accounts are held on public record, so there is increased visibility.
The next most important benefit of operating through a limited company is from a tax perspective. At a certain level of income, a limited company can be much more efficient than sole trader status. Limited companies have lower tax rates – 20 per cent, compared with as much as 45 per cent for a sole trader, where they are an additional taxpayer.
However, the income does belong to the company and there are additional tax charges payable by the owner on extraction. This is particularly prevalent following the recent changes to the taxation of dividends, which has seen the tax bill for an owner manager increase by around £2,000 per annum.
Optimising income tax
Taking the above into account, extracting some money from your company by way of interest charges on your loan account might present an efficient solution. In the absence of other income sources, this has the potential benefit of using the personal savings allowance, as well as the 0 per cent starting tax rate that is available for up to £5,000 of savings income, where taxable non-savings income is less than this amount.
By way of illustration, a company making £49,500 of profit could save over £2,000 per year where £8,000 is taken as salary, £9,000 as interest, and the balance of profit as a dividend. The saving is around £4,000 when compared to a sole trader business.
Where a husband and wife work together, these savings could be doubled. Clearly, interest cannot be charged unless money has been lent to the company. However, many individuals will lend to a newly established company on incorporation to get the business started, or (where a sole-trade is incorporated) may have created a loan account on incorporation when assets were transferred to the company.
If this option is pursued, there are certain obligations for the company and therefore professional advice is needed. An accountant can advise business owners on how best to set up their business and either draw profits or invest for future growth.
Rebecca Durrant is tax partner at Crowe Clark Whitehill.
Further reading on sole trader
