A limited company is a type of business structure that has been incorporated at Companies House as a legal ‘person’. It is completely separate from its owners, it can enter into contracts in its own name and is responsible for its own actions, finances and liabilities.
Advantages of a limited company structure
The most significant advantage for most people is limited liability, which means they are only responsible for business debts up to the value of their investments or what they guarantee to the company. However, there are many additional benefits, including:
– Tax efficiency.
– Credibility and professional company image.
– Opportunities for raising capital.
– Can be one person or multiple people setting up.
– Perpetual succession.
– Protected company name.
There are also however a few disadvantages to be aware of:
– Additional filing and reporting requirements.
– More complex accounting and taxation requirements.
– Potentially higher administrative and accountancy costs.
– Disclosing company information on public record, including details of directors and shareholders.
Tax benefits of a limited company
A limited company is a very tax efficient businesses structure because limited companies pay corporation tax on their profits of a flat rate of 19%. Directors can then minimise their personal tax and National Insurance Contributions (NIC) by paying themselves a mixture of a salary and dividends. Directors can also defer tax by leaving surplus income in the business bank account and withdrawing it in a later tax year.
Sole traders do not have the same tax benefits. They pay 20-45% Income Tax on all taxable earnings, as well as Class 2 and Class 4 National Insurance. There is no option for sole traders to minimise their tax or National Insurance liabilities, nor can they defer tax by leaving profits in the business to withdraw at a later date.
Tax efficiency is one of the main reasons why so many people set up limited companies or convert from sole trader to limited company.
Corporation Tax vs. Income Tax
If you run your business as a limited company, you will pay corporation tax on all taxable income. If you run your business as a sole trader, you will pay income tax on profits (above your personal tax-free allowance).
The benefit of a limited company is that you can minimise your Income Tax and National Insurance liabilities by taking part of your remuneration as a salary and the rest as dividends. To achieve the most tax efficient pay structure, you could pay yourself through a company in the following way:
– Take a director’s salary up to the Class 1 National Insurance Primary Threshold. No income tax applies to earnings up to this limit. You will only pay Class 1 NI on earnings above this threshold.
– Top up your salary by taking dividends. Dividends can only be issued when you have available profits. The first £5,000 of dividend income in a year is tax free. You will pay dividend tax above that amount, but you will not have to pay any income tax or NIC on your dividends because the company has already paid corporation tax on this money.
With careful planning, you could significantly reduce your income tax and National Insurance liabilities by paying yourself in this way. This is not possible as a sole trader.
Leaving surplus cash in your company
A limited company can leave some of its surplus income in its profit and loss reserves to use or withdraw at a later date. This can be beneficial if removing all of your trading profits in one financial year would cause you to become a higher or additional rate tax payer. If you do not require all of the funds, you can defer your personal tax by withdrawing some of your profits in a future year when it is more tax-efficient to do so.
It is not possible to do this as a sole trader because there is no distinction between business income and personal income. This means that Income Tax and National Insurance has to be paid on all profit in the tax year it is generated, regardless of whether the profit is left in the business or taken as personal income.