Should I Incorporate My Business?
Setting up your own company is an exciting time. Being your own boss, doing work you find fulfilling, the chance to grow and succeed, all these and more are reasons why people leave the safety of traditional employment to start their own businesses doing what they love.
A new business, particularly one that starts small, will usually begin as an ‘unincorporated’ sole trader, or a partnership if there are multiple people running the show.
In time, however, the company owner or owners may want to consider changing to an ‘incorporated’ business, of which by far the most common type is a ‘Limited Liability Company,’ usually referred to as a ‘Limited Company.’ In this blog we will give an overview of the difference between unincorporated and incorporated business, and some common considerations for business owners who are considering taking this step.
Unincorporated or incorporated – the difference
‘Incorporation,’ as the name may suggest, describes the process of forming a corporation. This will usually be a business, but charities, community interest groups, public services and more can all be incorporated. But what is a corporation, and how does it differ from an unincorporated organisation? There are many differences, but the central one is this:
An incorporated organisation is a separate legal ‘person’ from its owner(s), an unincorporated organisation is not
What this means is that if you have an incorporated business, legally that business is a separate entity to you (referred to as ‘corporate personhood’), whereas a sole trader or partnership makes no distinction between the business and the people who own it. If you purchase a van through your sole trader business, it’s your van. If you purchase it through a limited company, then the van is the property of the company.
This may seem a distinction without a difference, especially when you own the business and have complete control over it (through owning the share capital of the business), but the concept is very important because in most cases it significantly reduces the owner’s liability for what happens with the company (hence ‘limited liability’).
This creates a risk reduction effect if the worst should happen; if a sole trader takes out a loan, the business owner is liable for that money and will be in trouble if they’re unable to pay. With an incorporated company, however, the loan is taken out by the company and the owners are not directly liable for it. If the company fails and is wound up, the debt will disappear as well (though there are exceptions, incorporation doesn’t give you a licence to do whatever you want without consequences).
However, this also applies to income. Profit made by the business belongs to the business, not the owners. In order to get at these funds, the money has to be extracted, and if the company does fail then any available cash has to be used to service its debts before it can be distributed to the shareholders. We’ll look at extracting funds further down this article.
What are the pros and cons?
Naturally, the prospect of having a protective shield should the worst happen to your company is a significant benefit to incorporation. Equally naturally, having to extract profits if you want to enjoy the fruits of your labour is a drawback. That said, there are other pros and cons to consider:
Legal status: Incorporating provides your business with a legal status and certain rights under the Companies Act, which it wouldn’t receive as a sole trader or partnership. It also gives you the right to call yourself a company director, for those who like titles.
Legal responsibilities: That said, the Companies Act is mostly comprised of responsibilities for incorporated businesses and their owners. Failing in these can have repercussions, even with the protection of limited liability, ranging from fines to being barred from ever being a company director again.
Increased administration: Limited companies are required to file their annual accounts with Companies House, something unincorporated businesses aren’t required to do, and larger companies have to have an annual audit.
Transparency: Those who like privacy might wish to avoid incorporating, as company directors and major shareholders must have their identities publicly listed, and the company’s accounts themselves are also a matter of public record.
Potential to expand: Most limited companies are ‘private,’ but the option is there to become a public limited company (one whose shares are available on a stock exchange) which can raise significant additional funds, though this also increases the administration burden
Those are some of the main pros and cons of incorporation, presented in no particular order, but perhaps the most important consideration for many business owners looking to incorporate is:
What are the tax implications?
With all of the above said, this might be the most common thing people want to know when deciding whether to incorporate their business. To understand this, let’s talk about wealth extraction:
As mentioned above, the money earned by an incorporated company is not the legal property of the business owners. Profits stay with the company, and cash received sits in the company’s bank account. To claim this money, the shareholders can act in their capacity as the owners and controllers of the company to ‘instruct’ it to pay the money out to them as dividends. Because dividends are taxed at a lower rate than most other income types (between 7.5% and 38.1%, compared to 20% - 45% for employment income), and because dividends don’t incur national insurance payments, the effect is usually a lower tax bill compared to self-employment income as a sole trader.
However, that’s only half of the equation. As legal persons, corporations have their own taxes to pay, of which the most significant is the aptly-named ‘corporation tax.’ Since this is paid on profits, and dividends are not a deductible expense, this effectively means that the shareholders are taxed twice; once on the corporation’s profits, and again when the profits are paid out as dividends. For the smallest companies this can eliminate the tax advantages, or even increase the amount payable. However, after a point the reduced rates for dividend tax and lack of national insurance payments make enough of a difference that, overall, the end result is still a net saving.
In addition, a separate but important tax advantage of having an incorporated business is control. Self-employed owners of unincorporated businesses have to pay tax on all their net earnings in a year, whilst the owner of a limited company will only pay tax on the dividends they actually take out of the company in a period, meaning they can just extract what they need and leave the rest in the business for later, or make use of the generous tax-free pension allowances that are provided to companies who make contributions on behalf of their directors.
Furthermore, company directors (distinct from ‘shareholders’ but for small companies often the same person or people) are classed as employees and can opt to pay themselves salaries. Combining a salary with dividend payments is a common method used to create tax efficiency by making full use of the various allowances and reliefs available to individuals.
Incorporating is a major step for a business, and as such comes with a host of considerations for anyone thinking of it. Many see it as a logical ‘next step’ for their company, whilst others are put off by the increased regulatory burdens and complexities. One thing is for sure: if you’re looking at incorporating your business, you should seek expert advice centred around your specific needs and situation. For this, and many other things, Comera Professional are here to help.