One of the most common questions accountants are asked by small business owners is whether it’s worth forming a limited company, and if so, how to go about it.
The two most popular trading options for small businesses are sole trader and limited company, and which one suits you best will depend very much on the type of small business you run. It’s also worth remembering that if you start out as a sole trader, it’s relatively simple to change your trading status to limited company – but not as easy to change it back again.
What are the advantages of converting your business to a limited company?
It can seem more official to people you want to do business with – the term ‘limited’ gives the company a bit more weight. If you’re looking for investors, they will be more likely to oblige if you are a limited company, as their investment is protected, whereas if you are a sole trader or partnership there’s nothing to protect any money they put into the business.
Banks also prefer limited companies when offering loans and finance, as they can take out extra security so that if the terms and conditions of the loan are broken the bank can take some of the company’s assets.
The costs of setting up the limited company will probably be outweighed by what you save in tax, as you pay tax as an employee and can set quite a low salary. You also pay tax on ‘dividends’ the company pays you as a shareholder, but not any National Insurance.
The disadvantages of converting to a limited company
Your money isn’t technically your own any more. You can’t just make withdrawals from the business as you can if you’re a sole trader, and although it might be better for you in terms of paying tax, it does make your finances more complicated. As well as this banks will still require personal guarantees from the directors, which means that the directors can still be liable for the company’s debt.
As a result, your accountancy fees are likely to go up, as the accounts for a limited company aren’t as simple as those of a sole trader.
When you start trading as limited company all of your accounts are made public, and you must keep and file accurate records of everything because if you don’t there can be penalties.
How to make the change
The process of changing to a limited company is relatively straight forward – you can do it yourself or go through an accountant/agent. The paperwork is more daunting than the cost (it’s perfectly possible to set up a limited company from as little as £4.99 online).
If your business makes a profit of at least £20,000 a year it could be worth converting it to a limited company. You should allow for costs of about £500 to £800 in your first year after setting up a limited company, and you’ll have to remember to file your accounts and send an annual return every year (which you can also do online). You can hire an accountant to take care of all the paperwork for you if you want to be absolutely sure you don’t miss anything.
Tax and National Insurance Contributions
This is where a limited company finances can start to get confusing. Once you convert to a limited company, you become a director, a shareholder and an employee of the company, and you have to set up PAYE to pay yourself as an employee.
As a director and shareholder, you enhance your basic salary with dividends, which is where your tax advantage comes from, as you won’t pay National Insurance Contribution (NIC) on dividends. Tax and NICs have to be deducted via a company payroll, which you will have to set up. You also have to pay tax and NIC’s for other staff members if you employ them.
The amount of income tax you have to pay depends on what you pay yourself as a salary as an employee of your company, and the tax bands are the same as an employed person’s income tax, including the personal allowance of £10,600 (2015-16).
Corporation tax of 20 per cent also has to be paid on any of your company profits. You (or your accountant) will have to work out how much Corporation Tax you owe and pay HMRC within nine months of company year-end.
If your limited company makes a profit, the money can be shared out equally among the shareholders. This is called a dividend. Technically, even if there’s only one shareholder, and that’s you, you have to hold a board meeting to agree any dividend declaration, and record the minutes of the meeting in company records. It’s more a paperwork exercise than anything else but you still need to do it. It’s this sort of paperwork that can put sole traders off, but a good accountant will be able to advise you what to do.
You must keep paper records of all the board meeting minutes, as you may need to produce them if you’re subject to an HMRC investigation.
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