Setting up a business is an exciting time for many budding business owners. The business name, branding and your offering are often top of the agenda but one of the frequently forgotten considerations is tax.
In the first in our Lifecycle of a Business series, we consider some of the initial decisions you will need to make prior to setting up your business, and the varying tax implications of these options.
Producing a business plan
Creating a detailed business plan, after conducting thorough market research, is the first step when preparing to set up your business.
Key considerations that will make up the content of the business plan include:
- Defining the target market
- The products/services the business will provide
- How the business will be financed – is a loan or grant required for example?
- Looking at how long it will be before the business is able to turn a cash surplus
- What structure will be most suitable for those involved
Consider what type of business you wish to set up
When setting up a business, there are different structures to consider. These include:
- Sole trade
- Limited company
- Limited Liability Partnership
- Franchising options
You will need to decide on a structure that best suits your business model, as well as taking into consideration a variety of legal, commercial and administrative factors, all of which will impact on the suitability for your specific circumstances.
From a tax perspective, whilst all business structures can benefit from enhanced tax reliefs such as Business Asset Disposal Relief and/or Business Property Relief, there are other tax benefits and disadvantages specific to each type of structure that should be carefully thought through. These are considered here:
SOLE TRADERS AND PARTNERSHIPS
Sole traders and partnerships are relatively easy to set up, with low administration burdens. (We would, however, recommend that partnerships invest in a properly drafted partnership agreement to record how they will operate).
The National Insurance (NIC) due on profits are also at more favourable rates. Rates for the 2020/21 tax year are:
- Class 2 (profits of £6,475 or more a year): £3.05 a week
- Class 4 (profits of £9,501 or more a year): 9% on profits between £9,501 and £50,000, 2% on profits over £50,000
You may also be eligible for National Insurance credits if you’re self-employed and not paying NIC. These credits help to fill gaps in your NIC record, ensuring you qualify for certain benefits, including State Pension.
Partnerships sometimes provide flexibility in determining how both income and capital profits are to be shared that is not easily replicated in a corporate structure, and this can be useful in family businesses or in those that occupy property owned by the partners.
There is also an element of flexibility and relief within the Stamp Duty Land Tax regulations that can be helpful to partnerships where property needs to enter or leave the business.
Both sole traders and partnerships are subject to unlimited liability, meaning that partners and sole proprietors are personally responsible for any debt and liabilities accumulated by the business. Business and personal financial affairs are not legally separate if you are a sole trader or a partner in a partnership.
Profits are also taxed regardless of whether they are drawn or remain in the business – this can make a big difference depending on business size and profitability. For example, a self-employed individual with taxable profits at or below the personal allowance, and no other sources of taxable income, would pay no income tax. (There could still be liabilities to Class II and Class IV NIC).
On the other hand, businesses with a sizeable income (which is taxed at higher rates) may benefit from leaving their profits in a corporate vehicle if they do not need to be drawn on.
Whether trading as a sole trader or a partnership, early years’ profits may be taxed twice depending on the choice of accounting date. In this situation, these double counted amounts are deducted from profits when the trade ends. This is called ‘overlap relief’. Before deciding if self-employment/partnership is the most appropriate route, it is often worthwhile approaching an accountant to prepare some ‘what if’ calculations, based on projected profits and different accounting year ends.
Limitation of liability clauses for companies mean that the legal and financial responsibility for all debt and liabilities accrued by the business is reduced, meaning your business and personal affairs are separate.
Retained profits are also subject to lower tax rates than unincorporated businesses.
Most directors of limited companies pay themselves in some combination of salary and dividends in order to extract profits in the most tax efficient way. Dividends for example do not attract NICs, are taxed at a lower rate of tax than salary payments, and benefit from a tax-free dividend allowance. In comparison, salary is taxed at income tax rates, which are higher than the rates at which dividends are taxed, and may also be subject to employees’ and employers’ national insurance. However, the correct level of salary can be a cost-effective way of extracting money from the company, and can generate a national insurance credit for state pension purposes.
Deciding on the most tax-efficient way to pay yourself will depend on your specific circumstances, such as level of income, tax bracket it falls in and your national insurance contribution record.
Company share structures can be set up in a variety of ways and this can be useful long term in passing on the business to the next generation in a fair and tax efficient way.
Schemes such as the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEISS) may be beneficial to new businesses looking to obtain outside investment, as they offer tax reliefs to individual investors who buy new shares in your company.
As opposed to individual traders, the administration of a company can be a complex and time-consuming burden. Directors also need to be aware of their legal duties to ensure they are not at risk of any financial penalties or personal liability.
More specifically, individuals who sell their services through Personal Service Companies (PSC) may be affected by the implications of IR35, which removes any possible tax advantages. The rules mean that payments made to PSCs are subject to personal tax rates, including PAYE and NICs, rather than corporate tax rates.
If the business owners need to extract all of the profits from a company for personal income then the overall costs including tax of the business can be higher than a non-corporate structure.
There is also less flexibility for owners who want to be able to separate capital between individual owners. There could also be more complexity, and potentially tax, when considering moving property into and out of the company.
LIMITED LIABILTY PARTNERSHIPS AND FRANCHISING OPTIONS
The structures mentioned above are the most commonly used, and most appropriate for many businesses. In specific circumstances however, such as when multiple partners are involved in the business or the risks taken in the business need the protection of limited liability, a Limited Liability Partnership may be suitable.
A franchising option would only be applicable for specific businesses wishing to start their own company and trade under an established brand.
Our specialist tax team has experience in advising with these structures, and can provide further advice on their suitability for your individual circumstances.
Prior to setting up a business, that are numerous decisions to make, with complicated tax considerations, depending on the exact structure and nature of the business.
Our team of dedicated tax specialists are on hand to help you plan a tailored and tax-efficient approach to setting up a business, to suit your specific circumstances, ensuring you and your business maximise the tax opportunities available.
If you are considering setting up a business, and have any queries please get in touch with a member of our specialist tax team today.
In the coming months we will also explore in more detail tax requirements relevant to the business lifecycle, including choosing a year-end, pre-trading expenses, and registering for tax.