Jennifer Adams considers the advantages and disadvantages of incorporation.
Anyone starting a new business needs to decide which legal structure is best suited to the particular type of business being created, taking into consideration all the issues involved for each type, including the potential liability for any future business debts and the tax implications of their chosen structure.
Growing the business
It is invariably the case that a sole trader or partnership commences in business and the business grows such that the matter of incorporation needs to be considered. Although the decision to incorporate should be for commercial reasons rather than tax savings, any tax savings that may result need to be factored into the decision.
When a limited company is formed a new entity is created. Legally, this entity is separate from all other individuals, including the owners (shareholders) who may or may not be the same people as those who manage the company (directors). The directors’ and shareholders' personal effects are generally not available to meet the company's debts. However, on liquidation the liquidator has the right to 'look through' the company at the directors personally should he/she believe that the director(s) acted fraudulently.
Tax rates and personal circumstances
Until recently, one of the main reasons for incorporation was that the tax rate for companies was low compared with remaining self-employed or in a partnership. As every taxpayer's circumstances are different, the answer whether to incorporate or not must be calculated.
However, over the past few years tax rates have become increasingly realigned, such that incorporation is only beneficial should the amount of profit after tax and National Insurance contributions (NICs) is approximately £60,000 (this calculation assumes that the director/shareholder is the only employee, that all profits are extracted via salary at the NICs primary threshold limit 'optimal' amount (£9,568 for 2021/22), the remaining profit is taken as dividends, and the full personal allowance of £12,570 is available). Below this amount, the additional administration involved may not make it worth the cost.
Unless a company is created before the trade commences, incorporation means the disposal of a self-employed business to a new company. As such, the self-employed business ceases, which may lead to profit distortions in the final period if careful planning is not undertaken.
Tax issues of incorporation
There are tax costs related to incorporation that need to be considered, including capital gains tax (CGT), and possibly stamp duty land tax (SDLT) (or land buildings transaction tax in Scotland, or land transaction tax in Wales) should property be transferred to the company.
The disposal of assets and transfer of any goodwill to the company impacts on both capital allowances and capital gains and although there are various CGT reliefs available to reduce or defer chargeable gains made there are no specific reliefs available for the SDLT, etc. charge.
A director can borrow from the company with no need to complete online bank forms or have a clear credit rating or pay high credit card/loan interest, although shareholder consent is needed if the loan exceeds £10,000. There is a corporation tax charge of 25% if the loan remains unpaid nine months after the year end.
Outside of the tax implications, there are many other benefits for incorporating, not least the flexibility that the structure allows. Different categories of shares can enable different payment levels to be allocated, allowing the varying personal tax circumstances of individual directors to be considered separately.
Practical tip
The benefit of a company being a separate entity produces a quandary in that should withdrawals be required for personal use, payments in the form of dividends or salary or loan from the company each have their own tax implications. By contrast, a sole proprietor or a partner need not worry about these issues when they take money from the business for their personal use.
