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TaxationWeb by Mark McLaughlin CTA (Fellow) TEP

Mark McLaughlin CTA(Fellow) ATT TEP looks at where we are with the best structure for a new businessPicture the scene. A prospective new client strolls into your office seeking advice. He intends starting a new business, and asks whether he should operate as a sole trader, or in partnership (with his wife, who will be actively involved in the business), or through a limited company. Where does one start? The choice of the most appropriate trading medium will vary, depending on the circumstances. This article looks at some important tax and non-tax considerations in deciding on the most appropriate trading medium. For the purposes of this article, it is assumed that the IR35 rules do not apply.

The old adage of ‘not letting the tax tail wag the commercial dog’ still holds true. On that footing, the non-tax implications should strictly be considered first. However, let us start by looking at the tax considerations (after all, this is a tax publication!).

The ‘tax tail’

(a) Initial considerations

Will the business be more tax (and National Insurance) efficient operating as a limited company, a sole proprietor or a partnership? There is no definitive answer, as circumstances will depend on a number of variable factors, including the following:

• anticipated business profit levels;

• the extent to which profits will be extracted from the business, or retained;

• the level of remuneration payable by the company; and

• whether the taxpayer has other sources of income.

Sole traders and partners are taxed on business profits, whether those profits are retained in the business or withdrawn. A company can be particularly tax-efficient if used to ‘shelter’ profits at lower marginal tax rates for companies (main rate 30%) than for individuals (higher rate 40%). Sole traders and partners are liable to pay Class 2 National Insurance contributions at a flat rate, and Class 4 contributions based on profits, which are not tax deductible. Remuneration paid by a company is liable to Class 1 contributions (both primary and secondary), subject to corporation tax relief for the company. The level of Class 1 contributions can therefore be controlled to the extent that company profits are retained. However, the effective rate can be higher when profits are distributed.

To the extent that company profits are extracted, the tax and National Insurance position is influenced by whether the business owner receives salary, dividends or both. As mentioned, remuneration attracts National Insurance contributions, whereas dividends do not. However, since 1 April 2004, small companies (ie broadly those paying corporation tax at a rate less than 19%) have been faced with a 19% corporation tax charge (for financial year 2004) on dividends paid to non-corporate shareholders ( ICTA 1988, s 13AB and Sch A2 ). An unfortunate effect of this ‘non-corporate distribution rate’ is that the smaller the company’s profits, the larger the impact for tax purposes. A company with profits of £10,000, all of which are paid out to individual shareholders as dividends, would suffer an additional corporation tax charge of £1,900. For company profits of £20,000, £30,000 or £40,000 fully distributed to individual shareholders, the additional tax would be £1,425, £950 or £475 respectively.

However, the potential tax advantages of running a business through a limited company have not been eliminated. If no dividends are paid, the company tax bill is unaffected. If dividends are paid, tax and National Insurance savings are still achievable by operating through a company compared to a sole trader or partnership, albeit that the potential savings are lower than before the ‘dividends tax’ was introduced.

For capital gains tax taper relief purposes, the business asset status of the company’s shares is a major issue for its owners, particularly on a sale or winding up of the company. If profits are retained within the company, any funds surplus to present or future trading requirements should be monitored to ensure that the company continues to qualify as a ‘trading company’, as its activities must not include non-trading activities to any ‘substantial’ extent ( TCGA 1992 Sch A1 para 22A(1) ). The Revenue interpretation of ‘substantial’ is outlined in Tax Bulletin Issue 53 (June 2001) and Issue 62 (December 2002), which merit careful consideration.

(b) Timing of tax payments

Sole traders and individual partners are generally liable to make ‘in-year’ payments on account of tax (and Class 4 National Insurance contributions) on 31 January, and second payments of account by 31 July following the tax year. A company pays corporation tax on its income and gains nine months and one day after the end of the accounting period, unless it is a ‘large’ company for the purposes of paying corporation tax by instalments.

An unincorporated business with a year end of 31 March is therefore at a potential cashflow disadvantage in the timing of payments compared with a company. On the other hand, a year end of 30 April gives the unincorporated business a longer credit period. In addition, a company’s pay as you earn tax and National Insurance liabilities on remuneration are normally due within 14 days following the relevant tax month (or within 17 days if remitted electronically).

(c) Overlap profits

Another reason why 30 April may be an attractive year end for sole traders and partners is that most profits are taxable in a later year than made. Personal allowances may have increased, and tax rates may possibly be more favourable. However, there are potential disadvantages. For example, although securing an immediate cashflow benefit in the deferment of tax liabilities, this may have unfortunate consequences in the longer term when the unincorporated business ceases. The position will be exacerbated if profits have steadily increased over the years. Overlap relief will reduce taxable profits on cessation, but may be inadequate because the relief is based on lower profits of earlier years. The effects of inflation may further lessen the benefit of overlap relief.

(d) Pensions

A self-employed individual’s ability to pay personal pension contributions above £3,600 per annum broadly depends on the contributor’s age and level of profits. Higher rate tax relief can be claimed on contributions as a percentage of profits, up to an upper profit ceiling (£102,000 for 2004/05). Certain company directors and employees in non-pensionable employment may also be eligible to pay personal pension contributions.

For approved company pension schemes, contributions by the employer generally reduce profits for corporation tax purposes, and are not treated as the employee’s earnings for tax or National Insurance purposes. Pension contributions by the employee are relieved against earnings, within certain limits. Dividends do not constitute ‘earnings’ for pension contribution purposes. However, remuneration can form the basis for pension contributions in the same and the following five years, even if dividends are paid instead of earnings in those subsequent years.

A single pensions regime applies from 6 April 2006. An annual limit is introduced for contributions qualifying for tax relief (£215,000 for 2006/07). This limit applies to contributions by both the individual and employer. Tax relief for individuals will be given on contributions up to the higher of 100% of relevant UK earnings (subject to the annual contribution limit) and £3,600 gross ( FA 2004, s 190 ). Excess contributions by the individual (eg where low remuneration and high dividends are extracted from the company) will not qualify for tax relief. Employer contributions to a registered pension scheme will normally be eligible for tax relief in accordance with Schedule D principles.

(e) Losses

So far we have assumed that the new business will be profitable. But what if it makes losses? For sole traders and partners, flexible and generous loss relief is available against other income ( ICTA 1988, ss 380, 381 ) or capital gains ( FA 1991, s 72 ). In the first four years of a loss-making new business, ‘backwards’ relief for losses may be claimed against any income of the previous three tax years, earliest year first. Very often, a newly self-employed individual may have been an employee in years prior to the new business. It may be possible to generate useful tax repayments by carrying back trading losses against employment or other income.

Anti-avoidance provisions restrict loss relief for ‘non-active’ partners (ie involved in the business less than ten hours a week on average) in the first four years of a trade. Relief for those losses against general income and gains is broadly restricted to the partner’s business capital, with any excess losses being carried forward against future trading profits, or set against general income or gains of a later year if the partner makes a further contribution to the trade ( ICTA 1988 ss 118ZE-118ZK ).

A new company’s trading losses can only be set against other income and gains of the same accounting year, or carried forward against future profits of the same trade. Trading losses in later years may be carried back against other income or gains of the same and previous year, if any ( ICTA 1988, ss 393, 393A ).

(f) Wait and see?

New, unincorporated businesses with initially modest (or no) profits may later become successful. Incorporation could be considered when the advantages are more apparent. For tax purposes, it is generally easier for an unincorporated business to incorporate than for a company to disincorporate, i.e. cease trading, with the business continuing through a sole trader or partnership. There are no tax provisions specifically to assist companies in the disincorporation process. In addition, there are statutory procedures to consider when eventually dissolving the company. Starting out as a sole trader or partnership may therefore offer greater flexibility, provided of course that any non–tax (e.g. commercial and family) considerations are otherwise insignificant.

Sole trader, partnership or company?

(a) Sole trader

In the case of our new clients, both spouses will be actively involved in the business. As a sole trader, the business would therefore employ the spouse (see Example 1 ). Any business (unincorporated or company) paying the spouse a salary should ensure that it is justifiable in relation to the duties performed (Copeman v William Flood & Sons Ltd (1941) 24 TC 53), and is comparable to wages paid to any other employees who perform the same or similar tasks for the business. ‘Excessive’ remuneration could be challenged by the Revenue and disallowed in computing taxable profits of the business, on the grounds that it is not ‘wholly and exclusively’ incurred for business purposes ( ICTA 1988, s 74(1) ).

In addition, bear in mind that the spouse will acquire all the rights of an employee, potentially including the National Minimum Wage. However, in practice, family business owners who are directors generally fall outside the National Minimum Wage provisions if there is no written employment contract or other evidence of an intention to create an employer/worker relationship with the company.

Example 1 – Sole trader

Ozzy is opening a small garden centre business. His wife Sharon will be employed as full-time manager of the garden centre. Taxable profit for the year ended 31 March 2005 is expected to be £30,000, after Sharon’s salary of £15,000 (which is considered to be commercially justifiable) and employer’s National Insurance contributions. Business profits will be extracted in full. Ozzy and Sharon’s anticipated retained income from the business for 2004/05 is as follows:

Ozzy (income from self-employment)		Sharon (income from employment)
£		£
Profits	30,000	Salary	15,000
Personal allowance	(4,745)	Personal allowance	(4,745)
	25,255		10,255
Income tax:		Income tax:
£2,020 @ 10%	202.00	£2,020 @ 10%	202.00
£23,235 @ 22%	5,111.70	£8,235 @ 22%	1,811.70
Class 2 NIC	106.60	Class 1 NIC	1,129.48
Class 4 NIC	2,020.40	Total tax and NIC	3,143.18
Total tax and NIC	7,440.70
Net income retained	22,559.30	Net income retained	11,856.82
		Total income retained	34,416.12

(b) Partnership

Alternatively, the business could operate as a partnership involving both spouses (see Example 2 ). The allocation of profit between husband and wife requires careful consideration. The Revenue’s Business Income manual states: ‘You cannot challenge the apportionment of profits, as you can a wage, by reference to the value of the partners’ contribution to the firm’s activity’ (BIM 72065).

Example 2 – Partnership

Following on from Example 1, Ozzy considers operating the business as a partnership with Sharon instead, sharing profits equally. Ozzy and Sharon’s anticipated tax position and their retained income for 2004/05 are as follows:

Ozzy		Sharon
£		£
Profits*	23,157	Profits*	23,157
Personal allowance	(4,745)	Personal allowance	(4,745)
	18,412		18,412
Income tax:		Income tax:
£2,020 @ 10%	202.00	£2,020 @ 10%	202.00
£16,392 @ 22%	3,606.24	£16,392 @ 22%	3,606.24
Class 2 NIC	106.60	Class 2 NIC	106.60
Class 4 NIC	1,472.96	Class 4 NIC	1,472.96
Total tax and NIC	5,387.80	Total tax and NIC	5,387.80
Net income retained	17,769.20	Net income retained	17,769.20
		Total income retained	35,538.40
* Profits (sole trader)	30,000
Salary (Sharon)	15,000
Employer’s NIC	1,314
	46,314
Profits divided 50:50	23,157

However, the Revenue can challenge profit shares allocated to the spouse under the settlements provisions, if those profit shares are considered disproportionate to the work performed, and/or are uncommercial in relation to the capital contributed. The Inland Revenue’s interpretation and general approach regarding the settlements legislation is illustrated in its booklet ‘A Guide to the Settlements Legislation for Small Business Advisers’ which states (at paragraph 4.6.1):

‘Where the incoming partner receives a share of profits out of all proportion to the contribution made to the partnership, the arrangement would include an element of bounty.’
However, it may be arguable that the share of profits allocated to a spouse is a fair return for the commercial risk assumed by a business partner. In any event, the settlement provisions only ‘bite’ if the profit allocation results in a tax advantage.

(c) Company

Both spouses could be company directors and shareholders. Savings in tax and National Insurance contributions can be achieved through a combination of salary and dividends ( Example 3 ). However, care should be taken not to fall foul of the settlement provisions. Companies with husband and wife shareholders are subject to scrutiny if salary and dividend arrangements contain an element of bounty sufficient to constitute a settlement for the purposes of TA 1988, s 660A . This was affirmed by the recent decision of the Special Commissioners (albeit by a casting vote) in Jones v Garnett (2004) SpC 432, although the case is proceeding to the High Court.

Example 3 – Company

Continuing from Examples 1 and 2, Ozzy considers trading through a limited company. He and Sharon will be directors and equal shareholders (both contributing equally to the company’s fortunes). They each receive a small salary (£4,700 each), and the company’s post-tax profits are distributed by way of dividend. Their anticipated tax position for 2004/05 is as follows:

Company		Director shareholders (each)
£		£
Profits	46,314	Salary	4,700
Salary - Ozzy	(4,700)	Dividend (Inc. 10% credit)	16,675
- Sharon	(4,700)		21,375
Net profit	36,914	Personal allowance	(4,745)
Corporation tax	(6,392)	Taxable income	16,630
Additional tax on dividends	(506)
	30,016
Paid as dividend	(30,016)	Income tax @ 10%	1,663.00
		Dividend tax credit	(1,663.00)
		Net income retained	21,375.00
		Total (both individuals)	42,750.00

The payment of lawful dividends requires some care. For example, the company must have sufficient distributable reserves from which to pay a dividend ( Companies Act 1985, s 263 ). A review of the company’s accounts for the previous period provides an indicator of distributable profits. However, for a new business trading as a private company, the position is less straightforward. If there are no previous annual accounts (or if those accounts show insufficient distributable profits) ‘interim’ or ‘initial’ accounts are ‘necessary to enable a reasonable judgement to be made’ in determining amounts available for distribution, by reference to profits, losses, assets, liabilities, provisions, and share capital and reserves ( Companies Act 1985, s 270(4) ). Properly prepared, up-to-date management accounts may therefore be necessary if dividends are to be paid in the first accounting period, to reduce the possibility of unlawful payments being made.

For very profitable businesses (approximately £400,000 and above) where no or little profits are retained, the tax liabilities of an incorporated business and its owners will invariably exceed the liabilities of an unincorporated business, irrespective of the combination of salary and dividends extracted from the company.

A company is an easier way of spreading wealth between family members compared to an unincorporated business. For example, shares in a family company can be transferred into trust for future generations. However, great care should be taken when transferring shares (or business interests), particularly if family relationships are involved. As mentioned, the Inland Revenue can challenge arrangements under the settlements legislation in certain cases where income is diverted to someone else.

A company also allows employees to have a stake in the business through the holding of shares, possibly under an Inland Revenue approved share incentive scheme. However, remember that the business owners, in their capacity as directors, will be liable to tax on most benefits in kind from the company, which will be potentially liable to Class 1A National Insurance contributions at 12.8% (for 2004/05).

The ‘commercial dog’

Points to consider

There are numerous non-tax implications to consider before deciding upon the most appropriate trading medium, including the following:

• Simplicity - a sole trader is a more straightforward medium for starting a business.

• Liability (1) - a sole trader or partner is generally liable for business debts, to the extent of personal assets being at risk and even bankruptcy. A Limited Liability Partnership (LLP) is a possible alternative to a conventional partnership. It offers limited liability status for its members, and for tax purposes a trading or professional LLP is usually treated like a normal partnership.

• Liability (2) - A company can protect private assets against losses, because the liability of its shareholders to trade creditors and others is generally restricted to any amount unpaid on their shares. However, in many cases lenders or suppliers require personal guarantees from the directors against company debts, thus eroding the protection afforded by limited liability status.

• State benefits - entitlement differs for the self-employed, as opposed to directors or employees (e.g. jobseeker’s allowance is not available to the self-employed);

• Costs - the costs of forming a company and annual statutory compliance must be taken into account (e.g. the filing of accounts and an annual return to Companies House). The company’s accounts may also require auditing if the business is sufficiently large (i.e. turnover exceeding £5.6 million or gross assets exceeding £2.8 million). At the end of the company’s useful life, there is also the potential expense of liquidating or winding up the company. An LLP also has various compliance obligations and running costs. For example, to form an LLP, an incorporation document (Form LLP2 plus a £95 fee, decreasing to £20 from 1 February 2005) must be sent to Companies House.

• Law - a limited company is subject to company law considerations under the Companies Acts. The obligations for company accounts to be filed at Companies House for inspection by the public may deter some sole traders and partnerships from operating as a limited company.

• Restrictions - some professions (e.g. doctors) have their own rules to prevent partnerships admitting those without the necessary skills and qualifications, or to operate through limited companies (e.g. barristers).

Proprietors must properly understand the legal structure of their business. For example, owners of newly-formed companies often find it difficult to grasp the concept that the company’s money is not their own!

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’. Although only a discussion paper, it does suggest that the Government is considering changes aimed at ensuring that all small businesses pay ‘a fair amount of tax and NICs’, and invites comments on whether owner-managers of companies should be taxed differently to other company owners.

Conclusion

Firstly, there are numerous variables to consider when comparing the tax and National Insurance position of unincorporated and incorporated businesses. Circumstances will vary from client to client, and there is really no substitute for detailed calculations. Fortunately, there are software packages available to do the ‘number crunching’ for you!

Secondly, and perhaps most importantly, consider all the non-tax considerations when advising between a sole trader, partnership or company as a trading medium. After all, there is more to life than tax!

March 2005

MARK MCLAUGHLIN CTA (Fellow) ATT TEP
This article was first published in Tolley's Practical Tax, 11/02/2005.