In the past business owners have been rewarded with tax efficient remunerations for the risk that they take, which creates many jobs for the UK economy. For this reason, it was a shock to learn that the Chancellor will be increasing the effective rate of tax on dividends by 7.5% from April 2016. Alongside this, the 10% dividend tax credit is being abolished and will be replaced by a £5,000 tax-free dividend allowance. Therefore, if you include the personal allowance then fortunately business owners won’t pay any tax until they earn more than £16,000.
As a result of these tax laws, thousands of entrepreneurs are projected to have liquidated their businesses to maximise profit extraction. Although, disincorporation may not be necessary.
Example 1 Sole trader with taxable profit of £50,000:
| Total tax cost | £12,630.20 |
| Effective tax cost % on £50,000 | 25% |
| Net cash taken | £37,369.80 |
Example 2 Company with £50,000 pre-tax profit, where director draws £20,000 salary and £30,000 as dividends:
| Total tax on cost | £11,477.32 |
| Effective tax cost % on £50,000 | 23% |
| Net cash taken | £38,522.68 |
As you can see in examples 1 and 2, an increase in dividend tax still leaves the director £1,152.88 per year better off than the sole trader. So for tax reasons alone, if you own a Limited company it would be much easier and more beneficial to remain a limited company.
It is common for sole traders to experience sudden growth and think that the best thing for them is incorporation. There are other factors, besides taxes, that must be considered before changing the legal structure of your business. First of all, as a sole trader you have less contact with regulatory bodies for procedure such as the annual return. For this reason, it is much simpler for an individual to remain a sole trader.
A key factor for a large percentage of business owners is what kind of role you would like to play in the business. As a sole trader you are the owner, manager and proprietor – in essence you are the entire business and have full control to match. Alternatively, the director or officer of a limited company will own all or a proportion of shares, but they serve the company and often have less control.
However, a vital benefit to being a director is that you are a separate legal entity and unlike the sole trader, cannot be sued over any legal disputes. Unfortunately, without the right insurance Sole Traders can be personally sued. This also applies to any borrowing, as Sole Traders are fully liable for their debts. Therefore, if you are taking on staff, incorporation may give you piece of mind.
Please bear in mind that there are alternatives to becoming a sole trader or a limited company, such as the LLP. There is no real answer to whether being a sole trader or a limited company is better; you need to choose the right legal structure for your business. If this is something you are considering at the moment E R Grove would be happy to sit and ask you the key questions to work this out with you.
