Written based on FY13/14 United Kingdom tax legislations.
When setting up a business, one of the first considerations is regarding the legal structure. There are two main choices for legal structure for a start-up:
Sole Trade (or Partnership for multiple people) – Administratively very simple with profits being taxed as an extra trading income on an individual (in the case of a sole trader) or individual’s (in the case of a partnership).
Company – Administratively more complex as will involve filing as a company (incorporating) and compliance with company law and reporting procedures. Profits are first taxed at a corporation tax rate. To remit the profits back to an individual director/shareholder, there are two main methods:
- Salary (and bonus) to employed directors
- Dividend to shareholders
In reality, if an individual sets up a company they will become both a director and shareholder thus having the choice of the two options above.
A key consideration when choosing which business structure to go with is to reduce the amount of tax paid (legally). For a business owner, there are many tax impacts worth gaining an understanding over before making this decision.
Taxation of Profits
Sole Trader: The profits made by a sole trader are subject to income tax (up to 45%).
Company: The profits made by a company are subject to corporation tax (up to 23.75%). The remaining profits will still sit within the company framework and for profits to be delivered to an individual, they are extracted as salary to directors (up to 45% of income) and dividends to shareholders (up to 37.5% of dividend). For the company itself, a salary paid out to an employee (director) is tax deductible (saving having to pay corporation tax on that amount) but a dividend paid out to a shareholder is not deductible.
National Insurance Contributions
Sole Trader: When income is received by class 2 (up to £2.70 per week) and class 4 (up to 9% of income) national insurance contributions.
Company: When profits are extracted from the company and paid as an income to employees, this income is subject to class 1 employee (up to 12% of income) and class 1 employer (up to 13.8% of income) national insurance contributions.
Sole Trader: As a sole trader, pension contributions are made through a personal pension scheme.
Company: A company is able to make pension contributions on an employee’s behalf either to a personal pension scheme (independent of the company) or an occupational pension scheme.
Disposal of Assets
Sole Trader: The sole trader owns the assets personally and so a disposal of assets attracts capital gain tax on the gain at an individual’s rate of up to 28%
Company: The company owns the assets and so any disposal profits will be subject to corporation tax (not capital gains tax as for an individual). Again as above, the remaining profits will sit within the company framework and will require extraction to an individual by salary (employed directors) or dividends (shareholders).
There is no clear cut answer as to how to structure a start-up business. When considering tax implications of the structure of the business, as well as the above, further things to note include known future changes to tax rates, reliefs, losses, and the specific business in question.
Due to the unique ways that tax effects individual businesses, ever changing tax legislation and the complication of the interaction of different rules (such as reliefs – not discussed here), this guide does not constitute tax planning advice but rather offers a guide to common tax scenarios a business may find itself in. For specific tax planning advice, it is always recommended to see a tax planning specialist.
In addition this guide is based purely on current United Kingdom tax legislation.