Is it better to be a sole trader or a limited company?Side by side, there is no “better” choice. It is dependent on your business goals. The appropriateness is defined by the differences between the two options. Firstly, as a sole trader, you and your business are a single legal entity. This means you will share a single Tax File Number (TFN) and Australian Business Number (ABN). Your business income is your income. As a sole proprietor, if your business suffers a loss or becomes embroiled in some litigious issue, you are personally liable because you and the business are inseparable. You are one in the eyes of the law. If you opt for the company structure, you will be a separate legal entity from the separate business legal entity. Each entity will have its own TFN and ABN. As a company, any losses stay within the company, and any litigious issues will impact the company’s assets. Your home and other personal assets are potentially protected. We say “potentially” because your personal assets can be at risk where you have acted outside of the law. If you are going the sole trader route, then your legal entity will carry a name like this:
- Dave Walker t/as Dave’s Carpentry Services
- Dave’s Carpentry Services Pty Ltd
The advantages and disadvantages of the sole trader optionBeing a start-up means watching costs, and setting up as a sole trader is much cheaper and requires less time. The pros are:
- You are the business.
- You are the owner.
- You are the manager and the director, i.e. the boss.
- The less costly and faster setup process.
- Uncomplicated structure.
- Single tax return, single accounting fee.
- You obtain tax relief for expenses that are incurred wholly and exclusively for the purposes of the trade.
- If you can identify a proportion of an expense that relates to business, you can claim the same proportion against tax.
- A sole trader or partner can claim capital allowances on a car, disallowing a proportion for private use.
- You can obtain capital allowances on a computer.
- You will be able to claim a deduction for mortgage interest, rates, light and heat if you have an office at home.
- You can offset your trading losses against your other income.
- You may withdraw cash from the business without tax effect.
- You are free to borrow from the business bank account. It is your account.
- If your business bank runs at an overdraft due to the number of funds you have withdrawn, tax relief on bank charges and interest will be proportionately restricted.
- There is no requirement that you prepare accounts for tax purposes unless you are within Making Tax Digital for VAT: this imposes extra record keeping.
- Your accounts are not submitted to HMRC unless you are subject to an investigation.
- You can pass all or part of it down to the next generation.
- You can withdraw any profits, but it will not be classed as remuneration as you are not an employee.
- Low-income generating businesses could benefit tax-wise.
- No superannuation contributions are obligatory (Superannuation is money saved for your retirement and is an obligatory contribution as soon as you start working in a company.
- The personal assets risk is top of the list.
- If the business fails, you will be personally liable for its debts. You may go bankrupt.
- From 2013/14 on, there is a cap on the amount of relief that you may claim for losses and interest payments.
- There is no access to tax-saving income splitting.
- There are tax implications for death or divorce.
- Less wiggle room for tax planning.
- You may find that it is difficult to keep on top of your business, collect debts and work out profits without keeping accounts.
- When the business or assets used in it are sold, you are personally taxed on any gain under the Capital Gains Tax (CGT) rules.
- There is no adjustment for fuel benefit for you as a sole trader. You merely disallow a proportion of your fuel costs in relation to private use.
- In difficult times, such as the COVID-19 crisis in 2020, because you are self-employed, government support is likely to be based on your trading profits.
- The business ends if the sole trader dies or retires.
- Mobile phones will be subject to private use, so a tax add-back is expected on your tax return.
The advantages and disadvantages of the company optionsSetting up a company costs more than starting a sole proprietorship, and there is more complexity. That is far outweighed by the protection you get from your personal assets should losses or litigation occur in the business. The pros are:
- The business is a separate legal entity.
- The protection of your personal assets is top of the list.
- In the event of any legal dispute, the company will be sued unless it has a suitable insurance cover. It is exceptionally difficult and rare under UK law for anyone to sue a director personally for a company’s wrongdoing. There are exceptions where the ‘corporate veil’ may be pierced, and a director may be held personally accountable, e.g: In general law, where the director has perpetrated fraud:
- Where the director has committed specific offences such as corporate manslaughter, or under health and safety, environmental acts, companies acts and listing rules.
- In tax, in cases of fraud by the directors and for penalties involving deliberate concealment and offences by Senior Accounting Officers of large companies.
- The company pays corporation tax on its taxable profits. Company tax rates are lower than higher rates of Income Tax.
- The company obtains tax relief for its expenses if they are incurred wholly and exclusively for the purposes of the trade.
- If a director incurs private expenses through the company, they may be treated as earnings. If he or she is a shareholder, the amounts are treated as distributions.
- The company obtains full capital allowances on cars, irrespective of any private use by employees.
- Cars may be expensive as benefits in kind, but this depends on list price and the CO2 emissions of the vehicle. Providing you need to use one to perform your role your company can provide a computer without any tax consequences.
- Many different benefits and employment incentives can be provided free of tax (the company will obtain tax relief on the cost of providing these too).
- Mobile phones, one per household, can be provided if the contract is in the company’s name, tax-free.
- You can claim £6 per week without receipts for home expenses (£4 per week to 5 April 2020).
- Alternatively, the company can reimburse you for light and heat but not mortgage interest or council tax.
- As a director, you may set up a licence between you and your company to rent an office (or other space) in your home or outbuildings. This will enable you to recharge a proportion of mortgage interest and council tax.
- You will need to declare this as income and prepare rental accounts for Self Assessment tax purposes.
- It costs more and takes more time to establish a company.
- There are accounting fees for your personal income tax and accounting fees for your business income tax.
- There are two separate tax submissions.
- You must prepare annual accounts under the provisions of the Companies Act.
- HMRC require full accounts for Corporation Tax which must be submitted online.
- Accounts must be prepared in accordance with accounting standards.
- When it comes time to close the business, there can be a lot of professional costs involved.
InsuranceThere is usually no difference in the insurance requirements of a sole proprietor or a company. The difference is in workers compensation because when you are a sole trader/sole proprietor, you do not fit the category of an employee of a business. You do not pay worker’s compensation for yourself. If you establish a company, you will draw a salary from it, and you will be an employee of it. You may have to pay worker’s compensation based on your salary. Different legislation exists per state regarding companies with a single director. An accountant can verify the necessity.
Which is best?Your question should rather be: which company structure best suits my business model as it all depends on the type and size of business you are establishing. If your aim is to be self-employed and subcontracting your services to other companies, then a sole trader structure could well be very suitable. Even if you are selling direct to the public, if your intention is to “keep it small”, then don’t complicate it with a company structure. Should your aim be to grow and take on staff with larger projects and larger liabilities, then a company structure could well be the better option. A paid hour with an accountant or business consultant to answer a list of questions, including company structure questions, would be money well spent.
ConclusionIt is very important to take the time, albeit only a couple of hours, to get a good understanding from a professional in terms of taxation and asset protection. In the honeymoon period of opening a business, we don’t like to consider the worst, which is good or no businesses would ever open. However, it is very important to be prudent and take risk-appropriate decisions from the beginning for when the unexpected hits. Write up your business plan and your 5-year plan and take them to be tested. Find out now what your projected tax will be, or headcount or cost-saving opportunities. Run models on this with an accountant, and then you will be able to make a decision based on evidence and fact, not on a thumb suck and a gut feel. Now that you understand all of the pros and cons that come from either choice, do you know which type of business suits your business model best? Note that this article is merely intended as a guide to get your decision-making juices flowing and the correct steps in place before you make a decision about the future of your business. The second point of this article is to highlight the need for professional and prudent input. Remember, the more you know, and the harder you work, the luckier you get. We recommend that you speak with a financial advisor or business consultant before registering your company as either a sole proprietorship or a limited company.
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