When considering how to structure your business you will have to take account of a number of different factors.
Changes made to the tax system by Chancellor Gordon Brown in 2002 made incorporation very advantageous, and although subsequent changes in 2004 took away some of those tax benefits, the scales are still tipped in favour of incorporation. However, it is important to look at all the relevant issues before making a decision.
What business structures can I choose from?
A business may be set up as an unincorporated entity, such as a sole trader or partnership; or incorporated as a separate legal entity, such as a limited company or limited liability partnership (LLP).
Unincorporated entities allow greater privacy over your business affairs but with an increased risk, as sole traders or partners are personally liable for the debts and liabilities of their business. Sole traders are taxed on the profits of the business, and partners are taxed on their share of the partnership profits.
Incorporated entities are legally distinct from the individuals who form them, with the consequence that a company will exist separately from the directors and shareholders. This means that shareholders may die or the company may be acquired by new shareholders and its existence will continue, unlike a sole trader or even a partnership, where a change in partner causes a partnership to terminate.
Other consequences of the company being legally distinct are that third-party actions against the business are taken against the company, not the shareholders or directors, and the personal liability of shareholders is restricted to the amount remaining unpaid in respect of the company's share capital.
An LLP is another type of corporate body. The members - equivalent to shareholders in a company - have a restricted personal liability for the debts of the business but are taxed as self-employed, not employed, individuals. The LLP has to comply with certain disclosure requirements and file its accounts in the public domain like a company.
Setting up and running a company
Companies are normally set up with the assistance of a company formation agency, and the fee may be as low as £50. Once established, there is an annual requirement to file accounts and complete an annual return - the former will normally involve professional costs, and the latter an annual fee of £15 for electronic returns or £30 if you make your return on paper. There is also a certain amount of red tape, such as maintaining a record of board meetings and a shareholder register and ensuring that disclosure of information is correct in company materials.
When a company is established it must have a company secretary and at least one director. The director will manage and control the business on a day-to-day basis on behalf of the shareholders. The director owes a duty of care to the company, and if he acts fraudulently or negligently, then he may become personally liable for the company's debts and liabilities. It is, therefore, important for a director to know exactly what his role involves.
Money can be taken out of the company by way of salary or dividend or a combination of these. It is not possible to withdraw funds on an informal basis - as it is from a sole-trader business, for example - and loans from the company to the director may be illegal and/or have tax implications and so need to be carefully considered.
Companies, being separate legal entities, are subject to tax in their own right. The company prepares and submits a tax return for an accounting period within 12 months of the year end, and must pay the corporation tax due within nine months of the year end.
For the tax year to 31 March 2005 the rates of corporation tax are as follows:
Taxable profit Rate
Starting rate Up to £10,000 0%*
Lower marginal rate £10,001-£50,000 23.75%*
Small companies' rate £50,001-£300,000 19%
Upper marginal rate £300,001-£1,500,000 32.75%
Standard rate £1,500,000-plus 30%
\* Individuals receiving dividends from profits subject to these rates are liable to an additional charge which ensures that the overall rate of tax on the profits distributed is 19%.
Do I save tax by incorporating?
The answer is: probably. The situation is less clear-cut than it was before 2004's Budget, and it will be necessary to look at a variety of factors, such as the forecast profitability, the amount of profit to be retained in the business, and the marginal tax rate at which you pay tax. The interaction of these factors may be complex and they are best discussed with your professional adviser.
There are a variety of issues that need to be taken into account when deciding which business structure is appropriate for you. There will probably be a tax saving, but this needs to be balanced against the increased running costs of an incorporated entity. However, commercial considerations need to be taken into account, and the ability to ring-fence debts and liabilities may be very important to you.
Your professional adviser will be able to explain the pros and cons of the different structures and recommend what is appropriate for you based upon your personal circumstances and requirements and should be consulted before you set up a new business or consider changing from one type of entity to another.
Kevin Bexley is the business services director for Chiltern Plc.