When should a sole trader or partnership consider the move to incorporation? Lorna Bourke looks at the lower tax bills and access to finance that company status can bring - but finds that limited liability is often a myth.
It's often assumed that anyone seeking to start up in business should first set up a limited company - indeed, last year an estimated 400,000 entrepreneurs took the plunge and did just that. Yet at what point should a business consider incorporation, rather than continuing as a partnership or sole trader? And, further, what are the legal and financial advantages of doing so?
There are several common reasons for setting up a company; limited liability, the tax advantages and the increased ability to raise finance - it is almost always necessary to incorporate if a business needs new capital to expand. Yet the first of these reasons may be the least of the attractions in the early days.
'For a new company limited liability is something of a myth,' claims Michael Chartres of accountants Cooper Lancaster Brewers. 'Most people raise their finance from the banks, and the lenders not only take a charge over the company's assets but also expect personal guarantees - as do landlords. Limited liability doesn't give much protection but it does give some.' He cites the example of a firm with cash flow difficulties - in such circumstances some are tempted to leave bills for tax and VAT unpaid. 'If a company subsequently fails owing tax and National Insurance, the Inland Revenue rarely pursues directors personally for the outstanding amounts unless they suspect 82e fraud,' says Chartres. A sole trader or a partner would, however, be personally liable.
Others also highlight the restrictions on limited liability. 'For many small businesses there is no advantage in incorporating right from the start as the banks will demand that you give personal guarantees, which negates the advantages of limited liability,' says Grant Thornton's Andrew Godfrey. 'If you have only a couple of employees you probably won't need to anyway.' He also points out that suppliers rarely ask for personal guarantees.
For many, the higher cost of administering a limited company - particularly in the form of higher accounting fees - acts as a big disincentive. The fee for a company turning over £750,000 might be £3,000, but could be as high as £5,000 or £6,000 depending on the firm used and the amount of work involved.
Similarly, there is no point in incorporating if the person running the company needs to take all the profits as personal income - he or she will simply incur higher National Insurance contributions as both an employer and an employee.
As a result, there is no advantage in incorporating until pre-tax profits hit a minimum of £30,000 a year for sole traders - regardless of turnover. Here, the threshold for higher rate income tax takes effect, at which point it begins to be advantageous to leave surplus profits within the business and avoid the 40% income tax charge, paying only the small companies' corporation tax rate of 25%. If a spouse or other family member is employed the threshold is proportionately higher - £60,000 pre-tax profits for a married couple.
Here other advantages to incorporation become apparent. A company can, for example, set up a small self-administered pension scheme(SSAS) as a vehicle for legitimate tax avoidance. Contributions to a pension scheme are tax free and the scheme can be used to park surplus profits and build up a fund to finance future expansion of the company. A SSAS can also buy property for the company's use (up to 50% of the fund) and make loans back to the company. The equivalent self-invested personal pension available to the sole trader, partnership and the self-employed is not so flexible - investments in property are not allowed if classified as an associated transaction.
Leonie Kerswill of Coopers & Lybrand also feels that incorporation is inappropriate for the average small business. 'But when the business starts to make pre-tax profits of around £50,000 it's time to move. At this stage you can start to get away from unlimited liability. Once the business has been up and running for some time and has some assets, the banks may be prepared to take a floating charge and release the personal guarantees. But the most significant factor is that you protect yourself from claims for negligence.' Yet the usual trigger for incorporation is not so much the tax benefits or limited liability, though these are genuine. 'The major reason is the requirement for outside capital,' explains Kerswill. But she points out that many high-tech businesses have a limited requirement for capital because their assets are intellectual property and the skills of the workforce. 'The sort of professions that often don't need to incorporate until they are quite substantial are publishers, software firms and the like.' And, of course, there are also solicitors and architects, where even if they do incorporate, they cannot avoid liability.
With publishing and IT businesses, often all that is needed is an idea. Cash flow may be strong from the outset if the market is known and capital equipment, such as computers, can be leased. 'But you have to incorporate right from the start if there is any venture capital involved,' says Godfrey. Venture capitalists will want an equity stake in a business, which can only be taken if the business is a limited company. Kerswill also points out that a company structure is necessary if a business is to be passed on to a future generation. 'You can give away tranches of the business over a period of time and avoid inheritance tax altogether.'.