Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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April 2005

Q:

I am currently employed earning £30,000-35,000 a year. However, I am looking to start a business with a friend who is already registered self-employed. We are unlikely to make over £55,000 in our first year and I would like to know what the best route to take is i.e. whether we open as a limited company or not?

A:

The answer to the question whether it is better to trade as a limited company or an unincorporated business (i.e. as a sole trader or, in this case, a partnership) depends on numerous factors, both tax and commercial. It would be a mistake to look at the tax implications in isolation. Commercial considerations are therefore briefly discussed below. However, the major tax considerations generally include the following:

• anticipated profit levels – assuming that the figure of £55,000 represents profits as opposed to turnover, tax savings are achievable by operating through a limited company. However, as the business grows, at much higher profit levels (upwards of around £400,000), the combined tax liabilities of the company and its owners can exceed the liabilities of a sole trader or partnership if little or no profits are retained in the company, regardless of whether income is extracted as salary or dividends.
• whether profits are to be extracted from the company (e.g. as salary or dividend) or retained in the business. On a future sale or winding up of the company after a minimum of two years, the effective tax rate when retained profits are realised can be around 10% for a higher rate taxpayer, assuming that capital gains tax taper relief is available in full at the ‘business asset' rate.
• income levels from other sources – you are already using your personal allowances and most of your basic rate tax band. On this basis, your share of profits from a partnership will mostly be taxable at 40%. If you have no need for income operating as a company, profits could be retained to expand the business. As mentioned, if the company is wound up or sold after two years of trading, your capital gains tax rate could be as low as 10% with business asset taper relief.
• long term plans for the business – is the intention to continue indefinitely, or to sell the business after, say, a couple of years? A company is generally an easier way to spread wealth (in the form of shares) between family members, than it is to transfer an interest in an unincorporated business. However, the Inland Revenue may challenge arrangements to divert income from one individual to another, under anti-avoidance rules known as the ‘settlements' provisions. It is also generally more simple to sell shares in a company than the trade and assets of an unincorporated business, although potential purchasers may find shares less attractive, as they will be effectively taking over the company's history (e.g. regarding claims against the company, liabilities and so on).

For National Insurance contribution (NIC) purposes, business partners are potentially liable to pay Class 2 NIC at a flat rate (£2.10 for 2005/06), and Class 4 contributions based on profits (for 2005/06, 8% on profits between £4,895 and £32,760, plus 1% on profits above £31,720). However, as you are presumably paying employees' (Class 1) contributions on your present salary, the Class 4 NIC liability on your business profits will be all or mostly payable at a rate of 1%. This would also the effective NIC rate as a director or employee of a limited company, on most of any salary or bonus. However, there is no NIC liability on company dividends, so there is some scope for saving NIC by incorporating and receiving dividends, as opposed to salary (on which employee's and employer's Class 1 NIC is payable). However, company law requires that dividends can only be paid out of the company's distributable profits, which are taxable at corporation tax rates.

There are various other tax considerations in deciding whether to operate as a partnership or a limited company, including differences in the timing of tax payments, the effect of potential ‘overlap profits' for unincorporated businesses, and pensions (it should be noted that dividends do not count as ‘earnings' for pension contribution purposes). There is insufficient space in this article to cover all the considerations. Specific advice is essential.

Commercial implications

There are numerous commercial considerations in deciding whether to trade as a company or a partnership. These include the following:

• Simplicity – trading as an unincorporated business is more straightforward when starting a new business. It is generally easier for a partnership to incorporate later, than it is for a company to disincorporate and operate as a partnership instead.
• Liability – a partner is generally liable for business debts, to the extent of personal assets being at risk and even bankruptcy (although a ‘Limited Liability Partnership' offers limited liability status for its members). The liability of a company's shareholders to company debts and losses is generally restricted to any amount unpaid on their shares. However, in practice banks and/or suppliers may require personal guarantees from the company owners, thus affecting the protection of limited liability.
• Legal obligations – a company is subject to company law considerations, including the obligation to file accounts and an annual return at Companies House, which becomes a matter of public record.
• Costs – the costs of company formation and annual statutory filing obligations should be taken into consideration. The company's accounts may also require auditing if it is sufficiently large. At the end of the company's life, there is also potential expense in liquidating or winding up the company.

The future

The Pre-Budget Report 2004 included a discussion paper ‘Small companies, the self-employed and the tax system', which states the Government's belief that ‘the choice of legal form that a small business takes should reflect commercial rather than tax considerations'. The paper points to ‘underlying tensions' in the tax system disproportionately influencing the decision whether to operate as an incorporated or unincorporated business. In terms of small companies, it rather ominously states that ‘the rules can in some circumstances appear to be giving an unfair advantage to those who have adopted company form for purely tax reasons'. This paper does suggest that the Government is considering changes aimed at ensuring that all small businesses pay ‘a fair amount of tax and NICs'. If so, the distinction between unincorporated businesses and companies in tax terms may become less of an issue in the future.

Conclusion

Mark McLaughlin

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