Why do people choose to set up a limited company?

Statistically, most people who start a new business for the first time in the UK go down the route of operating as a sole trader, often overlooking the alternatives including the pros of setting up a limited company.

At the end of March 2020, before the devastating effects of COVID-19 were fully known, there were around 4.35 million incorporated companies  in the UK. That figure spiked when bounce-back loans were launched back in May, with many of those new registrations now suspected of being bogus.

That fraudulent motive for setting up a new company is not one of the advantages of going down this route, but it goes to highlight how differently your business may be treated as a sole trader compared to as a limited company.

Here are my top three advantages for setting up a limited company.

Limited liability

If you set up as a sole trader, you take on all of the responsibilities for running your business as a self-employed person and your business is treated as a single entity for tax and administrative purposes.

Being a limited company director offers you considerably more protection as the company will be treated as a separate legal entity, meaning clients or suppliers enter into a contract with the company – not you personally.

Should the wheels come off the company, directors are not responsible for any of its financial losses, therefore protecting assets like your income or your home. By contrast, sole traders have no protection should the worse happen to their business.

Tax & NI efficiency

Should the company make a profit in its accounting period, most directors extract income by taking a combination of a small salary, dividends and increasingly private pension contributions.

This attracts less income tax and dividends are not subject to either employer or employee National Insurance contributions (NICs), while pension contributions of up to £40,000 a year are placed into a tax-free wrapper until you retire.

By contrast, sole traders’ entire income is subject to income tax at their marginal rate – income tax rates are higher than dividend tax rates – and subject to NICs if they make profits of more than £9,500 in the tax year.

Operating as a limited company has benefited buy-to-let landlords from a tax perspective in recent years, for example, as the phasing out of tax relief for interest costs only applies to sole traders and business partners.

Easier access to finance

Cashflow, particularly at the current time with many firms relying on COVID-19 support schemes, is a real issue for all businesses. But it can be easier to secure finance as a director of a limited company.

Limited companies can raise much-needed capital by issuing new shares to existing shareholders or new investors to alleviate cashflow fears. Sole traders have to secure additional capital using their own resources, such as borrowing a loan against an asset.

It doesn’t always make sense to operate as a limited company and you can always change business structure, although it is nowhere near as simple as some advisers make out.

If you have a new business idea or want to change how your business operates, call me on 07803 782100 or email me at jon@red76tax.com to discuss your options.