The advantages of company over sole trader or partnership
Written by Ray Coman
Historically, companies were a popular choice for contractor and business owners. Companies were more tax efficient than unincorporated business, such as those run by partnerships and sole traders. They also offered the ‘veil of incorporation’, i.e. the credibility in a business setting of limited liability protection. Companies became a standard in the contracting world. Owing mainly to their abuse in facilitating arrangements which were employment in all but name as a way of saving tax, the rules surrounding IR35 tightened. When the burden of liability shifted to the paymaster in April 2021, many hiring companies either employed workers who were previously contracted or gave the ultimatum of providing services through an umbrella.
The 2021 Budget announced the introduction from April 2023 of a new rate of corporation tax. At first glance the announcement represented a shock hike in rate from 19% to 25%. However, tapering will occurring between £50,000 and £250,000, meaning the increase in tax will strike the more profitable business harder.
Over the years, the change in flat rate scheme for VAT, in dividend tax, in IR35 regulation and corporation tax has resulted in fewer individuals choosing a corporate vehicle. In this report we explore the circumstances in which company owners might still hold the edge over sole traders and partners in saving tax.
At the time of writing, the comparative tax rates for being a company are roughly the same as those of a sole trader of partnership. However, as explained above, from April 2023, many companies will face higher tax bills which poses the owners with a dilemma of losing limited liability and hassle of changing business status to save tax. However, we have outlined some of the remaining benefits which could tip the balance in favour of remaining as a company, especially for traders with profits north of £50,000 per annum.
For businesses run as sidelines or otherwise remain modest in profitability, there will be few obvious tax drawbacks to staying as a company. Most charities, community interest companies, trade and sports associations, service management and freehold property management companies will be unaffected by the changes.
Accumulating profits in the company to be extracted as capital when the company is dissolved is more tax efficient than the higher rate tax on dividends. This is because, with the exception of property management and other investment type companies, a company owner will benefit from business assets disposal relief on disposal of his or her interest. The payment on winding up of the company is referred to as a capital distribution. To benefit from the capital gains tax treatment, the company must satisfy targeted anti-avoidance provisions which include:
- It must be at least two years old.
- The business owner cannot be involved with another business in the same trade within two years of the capital distribution.
Paying someone else company profits who is taxed at a lower marginal rate. In practice, the addition of a shareholder is usually a spouse or family member with whom the company owner shares household or childcare costs. The arrangement can be facilitated by a partnership or even by hiring a spouse through a sole trader business. However, the rules are stricter for an incorporated business. The Partnership Act 1890 defines the arrangement as one in which two or more people work together with a common profit motive. However, corporate ownership does not impose the same requirement for its beneficiaries to work. A shareholder can have an investment interest only. An alphabet structure facilitates the arrangement whereby each shareholder can be paid varying amounts of dividend. Restrictions on the different share classes can be written into a shareholder agreement. A partnership, or LLP, generally requires profits to be distributed by a fixed portion. It is worth considering the benefits of a more flexible shareholder agreement, especially if the arrangement becomes more formalised over time.
Adult children can be paid dividend as part of a similar arrangement, for instance to cover the cost of university. By contrast, a dividend of over £100 paid to a minor child will be taxed on the parent.
Smoothing tax liability where profits are expected to fluctuate. A partnership or sole trader business is taxed on profits when they arise. By contrast, a company owner is subject to income tax on profits to the extent that these have been withdrawn from the business. For the most part a dividend is the amount transferred from the company bank account to personal bank account. This gives the business owner an opportunity to retain funds in the business bank account to be extracted in a future year when the marginal rate of tax will be lower. The circumstances in which this would be beneficial are when the company owner:
- Expects to be taxed at a lower rate in the approach to retirement.
- Emigrates from the UK. A non-UK resident is subject to tax on UK rental and UK employment earnings only. Dividend is disregarded as investment income.
- Anticipates profits to be higher for a period and then lower. This could occur, for instance, where the company is involved in a period of research followed by a product or service launch. Individuals involved in creative works, such as books and film production, and actors could have widely varying income over the span of a decade.
Pension contributions are highly tax efficient. While a sole trader or partner would obtain similar, if not the same, tax relief as a company owner, the company owner has the benefit of timing. A partner or sole trader is taxed on profits in the same year that they are made. An individual obtains tax relief on pension in the same tax year in which the contributions are paid. Thus, someone is required to pay in before 5 April to obtain tax relief for the current tax year. Consequently, to optimise tax an unincorporated business owner is required to commit cash to a pension in the same period in which the profits are made. By contrast, a company owner can retain profits in the business and pay into a pension when there is no other planned use for the cash. This carries us to the next point regarding re-investment.
A company has greater scope to time the reinvestment of surplus cash into capital. A partnership, LLP or unincorporated self-employment will obtain tax relief on reinvesting profits, however there will be less scope to time this decision according to business need. A company owner is not taxed on profits until taken out of the business. A reinvestment strategy dovetails with a long-term plan to extract accumulated profits as capital on eventual winding up of the business.
Service providers follow business models that are less capital intensive and therefore have less scope to channel funds back into the business. Advertising, employment roll out, commercial premises, business acquisition and IT upgrades could be opportunities to boost the future revenue of the business.
A low cost service provider will tend to have less opportunity to improve profitability through reinvestment than a business owner. A contractor will have less chance than a proprietor to improve long term profits through ploughing cash back into the business.
Starting April 2021, the Chancellor announced a super-deduction of 130% for investment in capital assets, such as computer equipment, office furniture and machinery. Electric cars will also benefit from the first year allowances.
In response to legislative reform, many business folk will now pursue their work as a sole trader or, if through joint venture, via a partnership or LLP. However, there are tax benefits to staying as a company dependent on circumstances. The decision about business structure can be cumbersome to change. Tax regulation is constantly changing. It is easy to speculate that the business tax regime, both for sole traders and companies could change again in response to inefficiencies in the marketplace and the condition of the nation’s balance sheet.