Starting out - limited company or sole trader

There are five million businesses in the UK and the majority of them are run as sole traders. If there is more than one person involved, then it's a partnership. But many businesses choose to trade through a limited company.

Limited liability

The obvious pro of running a business through a limited company is the limited liability status; the company can go bust and the owners - the shareholders - will not have to meet the company's debts. Partnerships can get similar advantages as Limited Liability Partnerships.

This is because a limited company is an entirely separate legal entity from its owners. The owners hold shares in the company. If a limited company is made bankrupt or insolvent, its shareholders will lose the amount that they have already paid out for their shares, and their liability is then limited to any remaining unpaid on their shares.

If a sole trader's business goes bankrupt the individual could potentially face personal ruin. The protection of limited liability is valuable. However, it has to be said that many of those lenders doing significant business with a limited company will want to protect their interests by requiring the directors to give personal guarantees for liabilities.

Running the company

A limited company is managed by its board of directors. A company may be run with just one director who can also be the sole shareholder. The director controls the company and has a statutory duty of care to act in its best interests.

The company is a separate legal personality and this makes it extremely difficult, other than for serious fraud, to hold a director personally accountable for his actions.

It is important to keep a proper division between what belongs to the company and what belongs to the owner/director. Blurring the distinction - especially cash - can have tax consequences.

Forming the company: tax breaks

Companies are easily and cheaply formed. When an existing business is transferred to a company, its assets are transferred to a new owner. If the transferred business already has a successful trading history then it will have value in the form of goodwill and other assets like property, fixtures and equipment. It would be possible to sell these assets in the open market, but a Capital Gains Tax (CGT) bill would probably arise.

The assets can be sold to the new company, either for its shares or cash. The 'money' can be left in the company as a director's loan, to be drawn as the company makes profits in the future. This is an extremely tax-efficient method of profit extraction as the owner is able to take advantage of a range of CGT reliefs that will either allow him to defer the capital gain or, more favourably, realise the cash value of the assets at a tax rate of just 10%, using Entrepreneurs' Relief.

Tax and running the company

Once the new company is up and running, the director will be treated as an employee for tax purposes. Any salary paid needs to be administered via a payroll, after deducting PAYE and applying employees and employers National Insurance Contributions (NIC).

The director will also be subject to tax on the cash equivalent of certain benefits like a company car. As an employee, the director qualifies for tax breaks including the provision, tax-free, of a mobile phone and work-related equipment such as computers. There is even scope for employer-provided lunches.

The downside is significant reporting obligations for the payroll and expenses. Care also needs to be taken over taking money out of the company - it will be tempting to just draw on the company's bank account but that could lead to a loan to the director with tax due.

Year-end planning

A company pays Corporation Tax (CT) on its profits. Assuming profits do not exceed £300,000, this will be at 20% although if there are other companies under the same ownership, the rate could be a little higher.

As a shareholder, the director will be able to take profits from the company via dividends. Dividends are not subject to NICs. Profits do not have to be extracted fully from the company each year and so, if the owner is a higher rate taxpayer, the company may be used as a "piggy bank"; profits may be retained in the company and taken when the owner is paying tax at a lower rate.

Paying a small salary (to preserve social security entitlements) and taking the remainder as dividends often means tax savings that well outweigh the cost of actually running the company.

By contrast, a sole trader or partner will pay Income Tax and Class 4 NICs on all the profits generated by the business with no method of sheltering profits from higher rates of tax (there are also Class 2 NICs). Then again, there are no tax charges for employment benefits for the self-employed and no special reporting requirements for expenses, other than to retain evidence of actual expenditure.

Filing requirements

Incorporation brings a range of additional reporting requirements. Companies are required to prepare financial statements in accordance with the Companies Act 2006. Accounts must be filed with Companies House by paper and online in a set format with HM Revenue & Customs (HMRC). HMRC also has compulsory online filing requirements for employment taxes.

Later on

If a company sells an asset, it will be liable to tax on the capital gain. Taking the sale proceeds out of the company can give rise to a further tax hit - the 'double charge' that needs to be managed carefully.

Having a company means others - perhaps the employees - can be given shares and so have an interest in the business. But giving shares can lead to tricky valuation and tax problems.

Eventually the owner may want to sell up, which may mean CGT, though the 10% entrepreneurs' rate may apply instead of the standard 18/28% CGT rate. And if Inheritance Tax is a concern, the business will probably qualify for 100% Business Property Relief, assuming the owner still controls the company.