What is the right trading option for you?
Jo Nockels, of TaxAssist Accountants, looks at the financial benefits of the different trading options available to a franchise owner when they launch their business
Deciding what to trade as – sole trade, partnership or limited company – is often not straightforward. Businesses are generally not obliged to operate under a particular entity. However, there are stark differences between them, so it is vital to weigh up the options before making a decision.
The advantages of incorporation
Investors prefer to put their money into a limited company rather than a sole trade or partnership, because if they purchase shares, their investment has more protection and their liability is limited to their shareholding (should the company run into difficulties).
Banks tend to prefer dealing with companies for similar reasons. Furthermore, they are able to take out extra security by lodging a ‘floating charge’ over the assets of the company, effectively meaning they get first call on those assets should the terms and conditions of the loan be breached.
Banks tend to look more favourably on franchise owners as they have the additional support of an established franchisor behind them.
The succession of shareholders
Transferring shares in a limited company is more straightforward than transferring a partner’s share in a partnership. The main obstacle would be if there was an unusual restriction in the company’s articles or a shareholders’ agreement.
Some expenses that would naturally be disallowed in an unincorporated entity can attract tax relief in a limited company. Subject to certain conditions, examples of these might include training expenses and pension contributions.
Effective rates of tax
The remuneration package for director-shareholders of small companies tends to consist of a small salary (large enough to ensure that they earn a qualifying year for state benefit purposes) and dividends.
Dividends are favourable because they are taxed at a lower rate of income tax than self-employment income and they attract no National Insurance. That National Insurance benefit was enhanced further in 2011/12 when there was a one per cent increase in rates.
The examples below indicate the 2012/13 tax savings that may be achievable for husband and wife who are currently in partnership and who share profits equally, have no other sources of income and who each take a salary of £7,488, with the balance – after corporation tax – paid out as a dividend (see table above).
Tax on withdrawals
Proprietors of unincorporated entities are taxed on their share of the business’ profits, regardless of what they actually withdrew. Companies are also taxed, but generally the rate of tax they pay under the current UK tax regime is lower than that for individuals, plus they pay no National Insurance on their profits. Therefore, incorporation might be appealing if the intention is to retain some of the profits within the business.
Seeing ‘Limited’ at the end of a business’ name gives the business some prestige and gives an illusion that the business is large. But this is perhaps less of a sticking point for franchise owners, who should be allowed to trade under the franchisor’s name anyway.
As long as the company remains on the Companies House register, no other company can be formed with the same name. Again, as with the status, this is perhaps less important for franchise owners who will be trading under the franchisor’s name, but it would protect the company name should the franchise owner have plans to go it alone in the near future.
The disadvantages of incorporation
Directors and shareholders of the company will have to complete personal tax returns and the company has its own filing requirements; it must submit its own tax return, annual accounts and an Annual Return. If the Directors are being paid a salary, the company will need to register as an employer and, therefore, complete an employer’s Annual Return.
Directors have a personal responsibility to deliver statutory documents to Companies House. Failure to do so leads to Companies House late filing penalties and can be a criminal offence.
While there is a perception that finance may be easier to obtain by companies, it is worth noting that it is common for banks to ask for personal guarantees from the Directors (particularly in newly formed companies), which means the Directors can still be liable for the company’s debts.
The company’s details and accounts are held on public record and can, therefore, be accessed by anyone. Furthermore, information about the company’s Directors, Company Secretary and shareholders can be accessed – although it can be limited to an extent.
Due to the level of reporting requirements, accountancy fees for companies are often higher than they would be for an unincorporated entity.
Separate legal entity
With an unincorporated business, the owners are free to make withdrawals without tax implications. However, the same is not true in a company situation, and Directors and/or shareholders can often struggle to draw a distinction between the company and their own affairs.
An unincorporated business holding assets with mixed-use, or making expenditure for both private and personal purposes, is pretty straightforward to deal with in terms of the tax treatment and disclosure. However, such items in a limited company can lead to tax charges, employer’s National Insurance contributions and additional reporting requirements.
Losses made by a sole trader or partner are far more malleable than if they had been generated by a company, and can, for example, be carried back (potentially up to three years in new trades), carried forward or even offset against capital gains.
This flexibility means that tax refunds could be generated, which can be particularly valuable to new businesses with a tight cash flow. Franchise owners can often generate losses in the early years because of the initial outlay of joining the franchise.
Before making a decision about what to trade as, discuss your circumstances with a professional, such as your local TaxAssist Accountant. They can talk you through the different responsibilities, reporting requirements and give you a rough idea of your tax liabilities under each entity.
Please note: This article is intended to inform rather than advise and is based on legislation and practice at the time. Taxpayer’s circumstances do vary and, if you feel that the information provided is beneficial, it is important that you contact us before implementation. If you take, or do not take action as a result of reading this article, before receiving our written endorsement, we will accept no responsibility for any financial loss incurred.